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The Human Factor In Evidence-Based Investing

Evidence-Based Investment Insights: The Human Factor In Evidence-Based Investing

In our last piece, “What Has Evidence-Based Investing Done for Me Lately?” we wrapped up our conversation about evidence-based investing in stock, bond and potential alternative markets. We also described how to extract the diamonds of promising new evidence-based insights from the overwhelming piles of noisy news.

We turn now to the final and arguably most significant factor in your evidence-based investment strategy, which is the human factor. In short, your own impulsive reactions to market events can easily outweigh any other market challenges you face, occasionally for better but usually for worse.

Exploring The Human Factor

Despite everything we know about efficient capital markets and all the evidence available to guide our rational decisions, we are still human. We have things going on in our heads that have nothing to do with higher reasoning. Instead, a brew of chemically generated instincts and emotions often spur us to leap long before we have time to look.

Rapid reflexes can serve us well. Our prehistoric ancestors depended on snap decisions when responding to predator and prey. Today, our child’s cry still brings us running, no questions asked. And their laughter elicits an outpouring of unconditional love.

In finance, however, where the coolest heads prevail, many of our base instincts cause more harm than good. If you do not know it is happening or do not manage it when it occurs, your brain’s chemistry can trick you into believing you are making entirely rational decisions when you are in fact acting on impulse. 

Put another way by neurologist and financial advisor William J. Bernstein, MD, PhD:

“Human nature turns out to be a virtual Petrie dish of financially pathologic behavior.”

Behavioral Finance, Human Finance

To study the relationships between our psychological and financial health, there is another field of evidence-based inquiry known as behavioral finance.

What happens when we stir up that proverbial Petrie dish of financial pathogens? Daniel Crosby’s “The Behavioral Investor” provides a guided tour of various academic findings that describe what is happening inside our heads to generate our financial behaviors:

“Our brains have remained relatively stagnant over the last 150,000 years, but the complexity of the world in which they operate has exponentiated. It would be a gross understatement to say that our mental hardware has not caught up to the times.”

To offer a couple examples:

  • When markets tumble: Your brain’s anterior insula lights up in its mammalian depths, just as it does when you experience physical pain. Fear drives the needle to “Sell!”
  • When markets unexpectedly soar: Your nucleus accumbens activates your brain’s arousal center, convincing you that you had best act soon to seize the day. “Buy!”

An Advisor’s Greatest Role: Managing The Human Factor

Beyond the market-timing instincts that lead you astray, your brain cooks up plenty of other sneaky biases to alter your investment activities. To name a few, there is herd mentality, recency, confirmation bias, overconfidence, loss aversion and sunken costs.

Your Take-Home

Managing the human factor in investing is another way an evidence-based financial practitioner can add value. By spotting where you may be falling prey to a behavioral bias, we can hold up an evidence-based mirror, so you can see it too. In the next installment of this series, we will explore some of the more potent behavioral biases every investor faces.

FREE FINANCIAL ASSESSMENT

With all the uncertainty and volatility in today’s economy, the time is now to take a thorough look at your finances. To accurately plan for your financial future, you must first know where you currently stand. For these reasons, our Success Team at Impact Advisors Group is offering a free financial assessment for both individuals and business owners. Request yours today!

This post was written and first distributed by Wendy J. Cook.

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