Don't let fear distort your thinking

published 12 December 2008

Imagine there's a cobra coiled inside a sealed glass box three feet away from you. As you approach, the snake rears up. What do you do? You leap back, of course. This is what psychologists call your brain's 'X-system', or 'fight or flight' reflex, kicking in. The argument is that when over the course of our evolution, this is what got us out of trouble. A rapid, reflex response to fear "carried a very low cost to a false positive", as James Montier at Socit Gnrale puts it at worst we wasted energy running away from danger. That's a price worth paying compared to "the potentially fatal cost of a false negative" being bitten or eaten. The trouble is, says Montier, sometimes it's better to think first and react later to use our more logical, rational and slower 'C-system'. And a bear market like the one we're in now is one of those times.

Emotional investors miss bargains

X-system responses are great when you're in physical danger. But they can let you down when investing. Take an experiment done by Shiv, Loewenstein, Damasio and Damasio in 2005. They set up a game lasting 20 rounds. You start with $20. At the start of each round you have two choices. Either you invest $1 or you don't. A coin is then flipped. A heads call wins you $2.50, as long as you invested. A tails flip means you lose your $1. That process is repeated 20 times, at the end of which you have made 20 decisions. So what's the correct strategy? A rational investor would invest every time. That's because the expected, or probable, payout per round is $1.25 ($2.50 x 50% + $0 x 50%) and the result from each has no bearing on the next. By extension, your expected outcome from 20 rounds is $25. That beats not investing to keep just $20 (which you have an 87% chance of making anyway by playing every round). Yet, when the experiment was run, most investors invested less than 40% of the time after a losing round. And the longer the game went on, the more anxious and risk averse they became. This is irrational X-system, rather than logical C-system, investing at work. So fear of losing money can end up costing you even more.

And it's not just retail investors who are prey to X-system thinking. Shane Frederik at the Massachusetts Institute of Technology created a three-question test (see below) on which most investors could score well by engaging slower, C-system thinking. Montier gave the test blind to more than 700 fund managers. Only 40% got all three questions right. It's not that 60% of fund managers are less able, but that they struggle to override their snap responses. Those same responses can lead sound stock-pickers to miss out on bargains.

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In short, fear of losing money can hold us back from investing (particularly if we've already lost money in the markets), even when our rational brain is telling us that stocks look cheap. So, what to do about it? First, make sure you have a strategy. If your chosen criteria, whatever they are perhaps low price/earnings, price/book value, or price/cash-flow ratios) are flashing 'buy', then go for it. Have an exit strategy too. Think about the return you want to make, and how much you are prepared to lose before you sell. By making the investment process as mechanical as possible, there's less chance that you'll be held hostage by your emotions. Then avoid situations that will kick your X-system into action. Be selective about the news you read grim headlines can make you panic. Instead, monitor your portfolio at set intervals, say quarterly. This will stop you panic-selling after a few days or weeks, racking up broking charges in the process. For more on the stocks that we think look cheap just now regardless of the overall direction of the market see this week's cover story: Bargain blue-chips for Christmas.

Tim graduated with a history degree from Cambridge University in 1989 and, after a year of travelling, joined the financial services firm Ernst and Young in 1990, qualifying as a chartered accountant in 1994.

He then moved into financial markets training, designing and running a variety of courses at graduate level and beyond for a range of organisations including the Securities and Investment Institute and UBS. He joined MoneyWeek in 2007.