Many martial arts rely on what is referred to as the “Circular Theory of Self Defense,” meaning that the momentum and exertion of an attacker can actually be used to your advantage. Imagine being rushed by a would-be assailant who speeds toward you with arms extended. Rather than meeting the full force of his momentum head on, you might side step this rush, deflecting the outstretched arm, leading him to rush past, now vulnerable to counter attack.
This approach of working with a powerful force and not against a powerful force is instructive to investors seeking to manage emotion en route to making wise investment decisions. It can be tempting to want to stop emotion in its tracks, but oftentimes, the more adaptive approach is to repurpose it for more favorable outcomes.
Behavioral finance is sometimes mistakenly seen as a vehicle for ridding investors of their pesky emotions and irrational quirks en route to them becoming something like the Homo Economicus that economists long imagined them to be. If we could just rid ourselves of irrationality, the thought goes, we would make perfect financial decisions. The only problem is, sometimes behavior that is irrational in the strictest sense of the word can greatly aid our quest to reach our financial goals. Being a behavioral investor is less about adhering to some textbook notion of rationality and more about understanding and bending the idiosyncrasies of human nature to our advantage.
Consider the work of Nobel Prize winner Richard Thaler, who first discovered and named what we now refer to as “mental accounting”, the tendency to separate money into different “buckets” and spend or save it differently depending on how it is labeled. Studies have shown that people are apt to save money labeled as a rebate but to spend money labeled as a bonus. President Barack Obama and his advisers, Thaler among them, used framing to position the stimulus given out after the Great Recession as a bonus to incent recipients to buy big screen TVs rather than hoard.
Read: Neighbors of lottery winners are more likely to go bankrupt
Also see: 12 things you can learn about investing from Nobel Prize winner Richard Thaler
This simple notion is the basis for goals-based investing or “personal benchmarking”, the process of intentionally dividing money into safety, income and growth buckets and investing it accordingly. It seems incredible that something as simple as labeling money can induce us to save and invest differently but as George Loewenstein says, “While it seems like an inconsequential process, earmarking can have a dramatic effect on retirement savings. Cheema and Soman (2009) found that earmarking savings in an envelope labeled with a picture of a couple’s children nearly doubled the savings rate of very low income parents.” Is it rational that we save twice as much money when someone plays on our feelings of love for our children? Absolutely not. Can we understand this about ourselves and use it to our advantage? Absolutely.
Meditate (seriously)
Meditation and mindfulness have been discussed with a sort of breathless reverence for the past few years that has led cynical skeptics like myself to want to run fast in the other direction. After all, things positioned as too good to be true often are, in both capital markets and life more generally. But in the case of meditation, a deeper dive into the research gave me a greater sense of what the fuss was all about and convinced me that perhaps thousands of years of spiritual practice was better informed than my naïve skepticism. If it’s good enough for Ray Dalio, Paul Tudor Jones, BlackRock, Goldman Sachs (all of whom have meditation programs in place for employees) and literally billions of practitioners worldwide, maybe it’s worth considering.
One of the central themes of this book is that working to slow down our reflexive thinking when making important financial decisions can lead to improved outcomes. To use Daniel Kahneman’s parlance, “thinking fast” leads us to rely on heuristics, biases and shortcuts, whereas the more effortful “thinking slow” leads us to consider decisions in their full contextual splendor. In one study, participants who took part in a mindfulness exercise and then were asked about their implicit associations with respect to age and race showed less reliance on bias than a control group who had not completed the mindfulness exercise. The simple act of slowing down and heightening awareness reduced reliance on well-worn biases and allowed participants to judge people of different ages and races on their individual merits and not as an overgeneralized whole. The positive potential for applying such nuanced thinking to investment decision-making can hardly be overstated.
Make it R.A.I.N
At times when strong emotion tempts you to stray from your investing rules, it can be useful to consider Michele McDonald’s R.A.I.N. model, a simple but powerful system for managing an episode of acute stress. The acronym is as follows:
Recognition — Deliberately observe and name what is occurring in your body and mind. For instance, “I feel my heart and mind racing.” Acceptance — Acknowledge and accept the presence of whatever you observed above. You don’t have to love it, but fighting will make it worse. Investigation — Ask yourself what stories you are telling yourself and examine what thoughts are present. Non-identification — Now that you have recognized, accepted and investigated your stress, you must realize that you are more than your emotions. You can feel something without being defined by it.Rational thinking can feel cold, sterile, and remote. Emotion on the other hand, feels pervasive, urgent and real. Because of its power to commandeer focus, emotion can lead us to conflate our emotional reality with external realities. By recognizing, accepting and investigating the antecedents of our emotional response, it can become another valuable piece of information as part of a larger tapestry of exploring the truth, and will cease to be mistaken for The Truth itself.
Automate, automate, automate
My book, The Behavioral Investor, nearly 300 pages in length, could easily have been three words long: automate, automate, automate. It likely wouldn’t have sold well, and you might have ignored the advice on account of it seeming too simple, but the fact is that many of the thornier elements of emotion can be done away with entirely by slavishly following a system of investment rules in all types of market weather.
This concept is most vividly embodied in the story of Odysseus, the Greek king of Ithaca, from Homer’s epic, The Odyssey. The king is best remembered for his decade-long journey home after the Trojan War, as well as the Trojan Horse he used to surreptitiously access enemy fortifications. But for our purposes here, we are less concerned about his skills as a warrior and more interested in what might be his most important action of all: an act of restraint.
In Greek folklore, Sirens were the dangerous creatures whose songs and beauty lured sailors close only to dash their ships along a rocky shore. But the Sirens weren’t just thought to be lusty mermaids, as they are commonly depicted today. No, the Sirens were reputed to have wellsprings of knowledge that could be whispered in the ear of a sailor but ultimately served of little use since they were the last words that he would ever hear. The trick, heretofore unaccomplished by even the most skillful sailor, was to gain access to the Sirens’ knowledge without paying the ultimate price for that wisdom.
After consulting with Circes, Odysseus arrived at a workaround; he would have his crew fill their ears with beeswax while he would have himself lashed to the mast of the ship. In so doing, his shipmates would be invulnerable to the Sirens’ whiles and he would still be able to gain access to the depth of their learning. As expected, as Odysseus heard the song of the Sirens, he flailed and begged to be unfettered but his men remained true to their discipline and did not give in to the pleadings of their leader. Just as Odysseus was a man of strength and action, many investors have been successful based on lives of boldness and proactivity. But in Odysseus we find an exemplar of the ways in which sometimes the most prudent action is restraint.
Even the most educated professional investor suffers from what is commonly known as "restraint bias," or the tendency to overestimate our ability to control impulsive behavior in the moment. If everyone in the world received comprehensive nutritional counseling, it would do nothing to change the fact that eating a donut in a period of stress is more satisfying than eating asparagus.
Likewise, giving in to panic selling or buying glamour stocks of poor quality are done, not because of lack of knowledge, but rather due to lack of restraint. The behavioral investor must tread the path of Odysseus, seeking to glean the best possible outcomes all the while cognizant of our own susceptibility to the stressors of an emotional moment. The behavioral investor must never forget that they would eat the donut too.
Daniel Crosby is founder of Nocturne Capital and author of “The Behavioral Investor” (Harriman House, 2018), from which this article is excerpted.
