Philosophy of Investment | To fight or flight – why risk can pay off

LONDON, Capital Markets in Africa — If you ask most people how they make decisions, they’ll probably tell you they look at the pros and cons carefully and, once they’ve weighed up all the evidence, they make their choice based on reason, logic and factual information.

In fact, this is not how people generally make decisions. They often make them quickly, based on intuition and gut feeling – and even apparently well-informed, considered decisions can have a big element of emotion in them.

In terms of what we’re designed for, this makes sense. If you were a hunter in Ice Age Europe and thought you’d seen a sabre tooth tiger, your reaction would be to get to safety as quickly as possible, even if it meant losing the mammoth you’d been tracking. The downsides of being caught by a tiger are so serious that acting first and thinking later is instinctive.

Even the more complex, modern day decisions lend themselves to an element of instinctive choice. If you’re thinking of moving jobs, it’s almost impossible to know all the information and, moreover, what constitutes a successful outcome isn’t necessarily obvious. So, if you can’t make the decision on facts alone, it makes sense to listen to your gut.

However, investment decisions are not normally like this. Firstly, unless you’re a day trader, they don’t have to be made in a few seconds. Secondly, outcomes are clear – you make a profit, a loss, or there’s no change. And, finally, it’s relatively easy to access large amounts of good information on which to base these decisions. Nonetheless, people will often make emotion-led investment decisions, even though doing so could cost them money.

Afraid to lose 
One of the biggest reasons for this is that most people do not see a £200 loss as the mirror image of a £200 gain. Research shows that the perceived “pain” of the loss is about twice as strong as the pleasure of the gain. This means, that if they’re offered a bet on a coin toss where heads wins them £350 and tails loses £200, they won’t take it, even though it’s a very good deal. This is sometimes known as “loss aversion” and has the effect of making people less willing to take investment risks than they should be.

A second reason is that when markets dip people’s desire to “do something” quickly kicks in. But this may well be the wrong reaction. There’s a strong chance the investment in question could rally if you can just hold your nerve. So the better decision is actually to do nothing because the balance of probabilities suggests that any loss will be temporary.

Impaired emotions

There’s plenty of research on how our emotions interact with investment decisions. One study showed that people with certain types of brain damage make better investors. The 2005 study conducted by a trio of American universities used participants with normal IQs but lesions on the parts of their brains which controlled emotions. These, the study proved, made them less likely to experience fear and anxiety and, as a result, made them better investors.

But what about people who don’t have this type of brain damage? Can we help them by taking the emotion out of investing? If we provide them with the right information and present it properly, can we stop them making poor decisions based on genes that were designed to prevent them being lunch for a sabre tooth tiger?

All the facts 
To help answer this question, Barclays recently ran an experiment on BBC Capital which was designed to combat the in-built biases in our brains. Users were invited to pick a fund (low, medium or high risk) and asked to click on a button to run the simulation. This then graphically displayed the performance of the fund over a five year period. Users could click on the button repeatedly to see different simulated outcomes. There was also an option to allow people to display all thousand possible simulated outcomes as a graph.

The idea behind the simulation was that its interactive and visual elements would help improve learning and recall; allowing people to experience the risk though sampling, rather than a dry numerical description has been shown to reduce biased decision making. Moreover, because it shows the ups and downs of an investment over time it gets people used to the idea of dips often being temporary and quickly reversed rather than the start of calamitous declines.

Perhaps the one outcome that the simulation made most clear is that, even with the riskiest funds, you are considerably more likely to make a profit than a loss. Investing is not like playing roulette – of course there is risk, but the outcomes are more likely to be favourable to you than not, and the chances of you losing your entire investment are very low indeed.

A second group was presented with the same data but only verbally and numerically. The results (chart one) were clear. First, those who used the simulation demonstrated greater overall comprehension of risk. Second, greater comprehension was associated with a greater willingness to take risks. This was backed up by further results which showed those who felt informed and confident in their decision were also more likely to choose riskier finds. Finally those who were better informed tended to make far more accurate estimates of potential losses, rather than over-estimating them. Taken together, all these results suggest that, the best way to fight market jitters is to give people good information – and to present it in a way that makes it most likely to sink in.

It seems then that, when it comes to investment, it’s actually the more thoughtful, better-informed people who take bigger risks and the impulsive, rash people who take the decisions that would, at first, appear sensible. If this feels really strange and uncomfortable, it’s because it runs counter to what over 99% of our species’ history has taught us. But, honestly, when was the last time you were chased by a tiger?

Source: Barclay’s The Philosophy of Investment, 24^th June 2015.