2018 was a volatile year. One that tested the resolve and self-control of many an investor. US equities, normally a relatively stable market, dropped 16 per cent in December with investors scrambling over each other to sell. What happened? Did a company collapse or did trade tensions spiral? Far from being the work of market forces this was entirely due to the force of our own emotions and instinctive reactions, Or in other word, our “lizard brain”.
We all like to think we are rationally decisive, making the best possible judgement with the information available to us. We also believe that we think as one mind with one thought process, coming to one conclusion. This assumption is, unfortunately, wrong.
Evolutionary biology means that the human brain is actually in a constant state of tug-of-war when processing information. On one side is the analytical mammalian neocortex and on the other our instinctive reptilian complex. The “reasoner”, our neocortex, takes time to analyse situations rationally and keeps us in control to make appropriate decisions at the right times. This governs our perception and deductive reasoning which fuelled technological and social advances. The lizard brain, our reptilian complex, reacts to things on an emotional level and pushes us into an immediate reaction. This governs our instinctive fight or flight which kept us alive in survival situations.
Financial markets are the perfect example to showcase the human brain at work and, unfortunately, the lizard brain often dominates.
While there are many reasoner investors who react to genuine concerns or opportunities after careful analysis, unfortunately there are many prone to lizard thinking – overreacting with immediate decisions being made on an all or nothing basis.
This might not seem like anything new – how many times have we all heard that a focused, rational mind with a long-term plan is the best way to beat the market? But there are times when the market moves in a direction, sometimes drastically, with no clear reason why.
In December there was a lot of noise around a possible US recession and global trade disasters. Fear took over and investors flocked to withdraw causing the S&P 500, one of the more stable indexes, to fall 16 per cent. This huge drop was simply caused by investors’ instinctive fear of a downturn with no true economic, political or financial calamities to justify this feeling.
Yet at Christmas time, when people realised the world wasn’t ending the index market rallied back to its November level. But does this mean that reason took over and re-established control in the markets?
Despite how it may look, this reaction too is rooted in the lizard brain. The positive US Federal Reserve meeting happened in late January, however the markets had already risen by 14 per cent before this took place. This rally occurred despite there being no significant change in the market. This is just “joy” replacing “fear” as investor actions were still governed by the lizard brain. This may seem positive but it exemplifies the fact that human emotion can sometimes be based on nothing and has too much influence over markets.
Over time, these fluctuations, which are more instinctive reaction rather than a considered decision, can cost an investor substantially. Between 1991 and 2013 US equity funds delivered an 8.8 per cent return per annum yet the average US equity investor return was only 6.87 per cent over the same period. This short-term emotional response has cost investors 1.93 per cent per year as they over- and under-react to news.
This irrationality in investing is obviously a very serious issue. It can turn slight downturns into major disasters and inflate a market well beyond its natural level.
We all have the capacity to let our lizard brain make investing decisions when the fight or flight instinct kicks in. A serious long-term investor needs to keep their lizard brain locked away when looking at the ups and downs of the market. Being able to spot genuine issues, trends and opportunities can only be achieved through careful consideration, knowledge and self-control.
Terence Moll is chief strategist at 7IM