Our own emotions create a major hurdle for us as investors. By the nature of our human mind we have destructive behavioral biases. Recognizing these biases and ingraining a better behavior into our investment approach will help us protect our portfolio.
Our minds have evolved through evolution over tens of thousands of years. We humans have two different system embedded within our mind according to psychologists. One system process information very quickly and is driven by emotions. Another system is more logical but it process information slowly.
Emotional System (E-system)
The system that is driven by emotions is our default response. It is capable of processing a vast amount of information simultaneously; we will call it the E-system. This system is quick and dirty and it is the older part of our brains. This is the part of our mind that will trigger the fight or flight response.
For example, lets say that we are at the zoo and we see a snake inside a glass cage. If we are told to go close to the cage and look at the snake and the snake then quickly rears up we will jump back. Even though there is class between us and snake and there is no chance of getting hurt. When the snake rears up on us a signal is sent to our brain. The signal first goes through our E-system which causes us to jump back to safety. Later the signal proceeds to the logical part of our brain that assesses the threat.
Logical system (L-system)
The part of our brain that process information in logical way was developed much later during evolution. It is capable of using a logical approach to problem solving; we will call this the L-system. The L-system looks at evidence and logic and is much smarter but it is also much slower. The L-system is only capable at looking at a limited amount of data at the time. It is the L-system that points out that there is glass between us and the snake in the example above.
Decision making and Investing
We all use both systems when it comes to decision making and studies shows that we tend to use the E-system more than the L-system. We are all overly vulnerable to our behavioral biases such as loss aversion, conservatism, impatience, over-optimism, overconfidence, and a confirmatory bias. The diagram below illustrates how our E-system process information from the market as an investment goes up and down in value.
The E-system is what our brain use by default when taking in new information from the world around us. But it is clear that we are better off using more of the L-system when it comes to investing and decision making. Fortunately we have the ability to consciously overwrite the decision made of the E-system with the L-system.
Psychologists have shown that we are more likely to use our emotional e-system during these conditions:
A. When are under stress
B. When we are interacting with others
C. When information is vague and incomplete
D. When we lack well defined goals
These problems can overcome by developing a strategy beforehand and having a well defined investment plan. Falling back on our investment plan in the heat of the moment will stop us from irrational actions and reduce our stress.
Warren Buffett said, Investing is simple but not easy. All you have to do is to buy assets for less than their intrinsic value and sell them above their fair value. Our worst enemy is not the market, our worst enemy is ourselves.