Chicago-based Markets Editor Jeremy Glaser spoke to Steve Wendel, Head of Behavioral Sciences at Morningstar. The insights Wendel shares can aid advisers in guiding their clients.
A strategy that you've talked about is trying to lock yourself in. What is it and why would investors want to do it?
The inspiration of the lock in is really Ulysses on the mast in the Odyssey. Where he knew that he would be tempted by the Siren's call. And so he had his crew members tie him to the mast so that he'll be unable to jump overboard.
(In Greek mythology, Sirens were creatures who sang a beautiful and irresistible song. It would entrance sailors who would be lured to their deaths as they steered toward the call only to be dashed to pieces on the rocks. Odysseus, the wandering protagonist of Homer’s Odyssey, ordered his crew to tie him firmly to the ship's mast so he could resist the temptation and sail on safely.)
I think this is very good metaphor for what happens in volatile times. We know that we might be tempted by wanting to tinker with our investments or go all out when there is a problem in the market.
Now we have strategies that are really strictly tying us to the mast where you set your investment goals, you've set your investments and you remove the power to change. Either because the vehicle itself is a long term investment vehicle and you are not able to leave or you require another signatory - someone else is involved before you can take action, which stops you.
Then we have somewhere where the the bonds are a little bit looser. For example a social friction where you tell your friends or colleagues that emerging markets are a terrible idea and why you believe so. Two weeks later you see that emerging markets are really ramping up. You have that social friction in your mind that acts as a guard – “I just told these guys this, now I don't want them to think that I am inconsistent and a bad investor.” That puts that little bit of friction that stops you from making a poor choice.
Returning to that planning mindset. Why is that there’s something you might want to do?
It's important to remember that when we decide our investment goals or a particular portfolio, we are usually in a very conscious, thoughtful, calculating mode. Psychologists call it your System 2, which is conscious thought.
(“System 1” thought processes operate automatically, process information fast, are influenced by context, biology and past experience. In contrast, “System 2” thought processes are deliberately controlled, effortful, intentional, and require justification via logic and evidence.)
But when we are responding to signals in the market, whether it is someone on TV or something we are reading, or a general fear that grips society in a serious market downturn, we're in a very different mode of thought. We're emotional, being driven by our intuition - System 1. It’s a very separate part of your brain that’s working. And so one way to counteract that is to try and return to that conscious planning mindset. It's a common statement, but it's true.
You take a break first and foremost, second you return to your original principles. So how did you work out this particular investment portfolio? You go back to that document and force your mind to go through those steps - that gets you back in the conscious thoughtful mindset and avoids these gut reactions.
How do you really know your limits? How do you know you are still falling off to know that you are back in that mode?
Why would we want to go through all this trouble when the market is going crazy and we have to act right now? Well, we have to know why that’s so dangerous, we have to know our limits.
One of those limits, perhaps the most important, is simply how our ability to resist temptation changes over the day like a cycle. There was a study of judges, where they looked at parole rates over time. The parole rates went from 70% to 80% down to 0 over the course of a few hours, where judges were giving most people parole to almost none. The only difference was a few hours - same type of inmate and same question. The reason: Judges were getting hungry and tired of making these complex decisions.
We face the same thing. We don’t know how much simply being at the end of the day and being tired affects us and makes us harder to resist temptation.
Or, for that matter, having gone through a series of reports or going through a series of investment decisions makes that last one, that last choice, so much easier for us to make a stupid choice.
When we get tired at such a basic level, it's glucose in the brain that just gets worn out. If you feel this mania and you have difficulty concentrating, that’s the sure sign that your self-regulation resources are being depleted and you need a rest.
If you have difficulty thinking about other topics, that’s another indication that your mind is tunneling as we call it. You may be very good at thinking about that but you are not thinking about all the other options. So if you find yourself extraordinarily focused that’s another sign.
Is there any way to use these biases in your own favour?
Absolutely. So when you are seeing the stock tickers go by and you see the markets tanking; that’s extraordinarily vivid, it's real, it's immediate in your mind. You can see yourself losing money. Our minds think that the things that are most vivid are the most true, they are the most likely. So I see this crash and I see that I am going to lose all my money.
So one strategy is to fight vivid with vivid. (Advisers can use this with their clients.) You say: how can I make thoughtful, careful, long-term portfolio choices and investment strategy just as vivid. How do I look for articles or where people are talking about how good your existing investment strategy is? That’s not to say, you want to just confirm where you started and say I'm great. But rather it's fighting vivid with vivid. Fight it with something else that’s just as much in your face. You are using our bias towards things that are vivid and you are using it in the favour of your long term, thoughtful investment choices.
