This is your grandfather from 50,000 years ago. You don’t know his name. Let’s call him G50K for the sake of convenience.
His tribe was just learning to use words for communication.
He was still a hunter-gatherer. He lived in a nomadic group. He spent all his day trying to avoid predatory animals. He had to find shelter to survive in summer, winter, and rain.
He had to forage for food every day, otherwise he would have to sleep hungry.
It’s been that way for much of the human history.
Modern humans evolved 200,000 to 300,000 years ago. In contrast, the oldest stock exchange in the world — the Amsterdam Stock Exchange — was established in the year 1602.
Our brains evolved over hundreds of thousands of years to perform the tasks necessary for survival. From the perspective of human history, the stock market came into existence only 17.28 seconds ago.
Your G50K’s brain was not wired for the stock market
Evolution doesn’t feel sorry for not customizing our brains for the stock market. Survival has been the most important thing for the longest part of human history. It’s still more important than Nifty 50 and Nasdaq 100.
We are wired to run away from things that cause us pain. We want more of the things that give us a sense of security and pleasure. It has helped our ancestors survive the challenges of life.
Evolutionary psychologists Leda Cosmides & John Tooby have written that “Our modern skulls house a Stone Age mind.” They further wrote:
Generation after generation, for 10 million years, natural selection slowly sculpted the human brain, favoring circuitry that was good at solving the day-to-day problems of our hunter-gatherer ancestors — problems like finding mates, hunting animals, gathering plant foods, negotiating with friends, defending ourselves against aggression, raising children, choosing a good habitat, and so on. Those whose circuits were better designed for solving these problems left more children, and we are descended from them.
Our brains are not particularly suited for investing. Let’s look at how the same emotions and behaviors that helped our ancestors survive can wreak havoc in stock market investing.
The warning system
There is an almond-shaped thing in our brain. One on the left side and another on the right side. It’s call the amygdala.
It’s like a warning system, meaning it plays an important role in our behavior and emotions. It gives us the ability to feel emotions like fear and anger, and perceive similar emotions in others.
My wife is scared of lizards. Once we were sitting with our family members in a room, and my wife’s younger sister threw a lizard made out of wheat flour at her.
While the lizard was still in the air, my wife jumped out of sofa and ran out of the room, screaming! She crashed into a wall even before she could realize that it was a fake lizard made out of wheat flour.
Her amygdala sprung into action instantly and made her flee. It didn’t wait for her rational brain to understand the context and validate whether it was a real or fake lizard.
We get to see a similar fight-or-flight response in investing. When the news channels are screaming about the crisis and everyone around you is talking about the Greatest Great Depression since the 9th century BC, our amygdala is going to kick in even before our rational brain can get a clear picture.
In a study, researchers found that the more frequently we are exposed to the stimuli that we are losing money in the stock market, the more active our amygdala becomes.
In a separate study, Harvard researchers have found that even the expectation of a loss makes our amygdala insanely active.
The strong emotional response triggered by amygdala is not always a bad thing. It also comes into action when we think of taking big risks with our money. It saves us from serious threats in a way.
The false alarm
When your G50K saw a cheetah running towards him, he would run faster than Usain Bolt or climb up a tree to save his life.
A few moments later he realized that it was just a harmless animal, not a hungry cheetah. A false alarm. He would get down the tree and walk peacefully towards his destination. He didn’t lose anything.
Had he underestimated the risk and it turned out to be a real cheetah, he would have become a sumptuous meal for the wild beast. So, his brain had to be extra careful of the potential risk.
Fast forward to present day.
The stock markets worldwide crashed more than 30% in March 2020 due to the COVID-19 pandemic. The experts on financial pornography networks were 101% certain that we were in the greatest economic crisis since the 1929 Great Depression.
It felt like a cheetah was chasing us. And we had to run away by selling our stocks before the markets went down to zero.
As days and weeks passed, we realized that the economies were slowly opening up, markets were recovering, and the regulators were printing truck loads of money every day to minimize the impact of the crisis.
But if we sold in panic at the bottom in March 2020, we lost tons of money. We converted the losses on our screen into monetary losses in the bank account.
The false alarm didn’t cost anything to your G50K. But it could cost you a fortune.
Short-term and long-term
Financial advisors, asset managers, and other experts are always telling investors, “Just ignore the short-term volatility, and focus on the long-term returns.”
The advice is valuable, logical and reasonable. Compounding is indeed one of the most powerful forces in the world.
But it ignores human emotions. We are full of fear, greed, anxiety, envy, ego, etc. that cause us to break any rule.
We have evolved to focus on the short-term. So, it’s incredibly difficult for us to take a long-term view.
When your G50K felt hungry, he wanted a meal right now…even if it was a small meal. He would not listen to anyone who told him: “Ignore the short-term and focus on the long-term.”
We want short-term gratification, even if it’s smaller than what we could get in the long-term.
It helps explain why most investors like to book short-term gains instead of staying invested for decades.
We are rational, too
If the amygdala is always causing fear, anger and other strong emotions, we will probably never be able to live peacefully.
Evolution has gifted us with the prefrontal cortex in the brain. It stores memories of various events, to be used as data for the future decisions. It helps us reach a rational, balanced judgement.
The prefrontal cortex moderates the executive functions of the brain such as decision making, social behavior, and personality expression. It ensures that we aren’t always acting emotionally in life and in the stock market.
Hungry for prediction
There is a reason analysts are always predicting the future despite knowing that a dart-throwing chimpanzee has a better track record than them.
It’s because we crave predictions. We want to know what is going to happen.
Look at the image below. I have deliberately left the circles in the bottom row blank. But your mind will automatically try to find a pattern, and probably predict that the blank circles should be filled with yellow, red, and green colors…in the same order as the first two rows.
It happens because our brains have evolved to predict. If your G50K stopped anticipating or predicting where the next meal could be found, he would starve to death.
He had to learn to identify patterns and make predictions. We have been spotting patterns and anticipating future events for hundreds of thousands of years. It happens to us unconsciously, just like the heart beat.
When your financial advisor tells you, “Don’t try to predict the markets,” he is trying to undo in 3 seconds what evolution has accomplished in 300,000 years!
A broken pattern
Imagine this: You are in your car, stuck at a traffic signal. You are staring at the red light. Your mind unconsciously starts picturing the lights turning from red to yellow and then green.
The lights have turned yellow now and you have started your car. But instead of green, a violet light appears out of nowhere and the cop signals you to wait for another minute.
The unexpected appearance of the violet light is going to drive your frustration 10x higher. It’s not the pattern your mind has become used to.
If a strong pattern is broken, our emotional reaction also tends to be strong.
A stock that has beaten the consensus estimates for 2–3 consecutive quarters gets people excited just by sharing the date of the next earnings announcement. We start predicting it will beat the consensus again.
But when the results fall below expectations, our brain reacts strongly, which makes us sell our shares. Companies lose thousands of crores in market value when they miss earnings estimates by a few paisa per share.
Evolutionary biologists have found that the longer a pattern has been repeated, the stronger our conviction becomes in it. And the stronger our reaction is when the pattern breaks.
We are not immune to our emotions
No matter what someone tells you, 99.99% of us are not immune to our emotions when it comes to money.
Let’s assume you are not in the other 0.01%. The 0.01% are folks like Warren Buffett and Charlie Munger who memorized 37,962 mental models in school.
What’s challenging for most investors is sticking to the process through ups and downs while dealing with our emotional brains that our G50K gifted us.
It’s one thing to read or tell someone, “This crisis is just a short-term thing, you should focus on the long-term compounding.”
It’s an entirely different thing to not freak out when your portfolio is down 40% in the midst of a crisis, your company is laying off employees, and your daughter is about to start college.
You are going to freak out to some degree.
We want to be rational and logical. We convince ourselves that we are. But we aren’t.
We want to believe that emotions and behaviors affect only other investors, not us. We forget that we are also imperfect, emotional beings.
How not to be your own worst enemy
Our emotional brain hasn’t yet evolved to catch up with the stock market. Evolution is a slow thing. But always acting on emotions is the most terrible thing you can do to your portfolio.
Minimize the chances for your brain to panic
Morgan Housel, a partner at the Collaborative Fund and author of the book Psychology of Money, likes to keep plenty of cash that he can access anytime. Having excess cash might sound irrational to many investors, given the low interest rates. But it works for him.
Why would someone as smart as Morgan do that? He has said on numerous occasions that the extra cash gives him mental peace. It minimizes the risk of him panicking in a market crash and selling his equity investments at the bottom.
We’ll get the best returns if we let our investments compound for decades uninterrupted. And panic selling kills compounding right before it starts showing its magic.
The extra cash minimizes the risk of selling equity to meet the unexpected expenses if life throws a surprise. Allocating a portion of our portfolio to relatively safer assets such as bonds and gold also gives us mental peace.
According to a study, “having readily accessible sources of cash is of unique importance to life satisfaction, above and beyond raw earnings, investments or indebtedness.”
Make good behaviors your default option
There is a reason we continue to pay for various memberships or subscriptions that we don’t use much. We don’t cancel them even though we know we should.
It’s not about irresponsibility or laziness. It’s because canceling them requires deliberate action and energy on our part.
We are psychologically wired to take the path of least resistance due to the status quo bias. We don’t want to go out of our comfort zone to make a change, until and unless the change becomes absolutely necessary.
If we make good behaviors our default option, we are making the status quo bias work in our favor instead of against us.
Even when your emotions tell you to make a bad decision, the very fact that you have to take the time and go out of your comfort zone to act on it reduces the chances of you pulling some irrational sh*t.
It is particularly useful because it eliminates the need for our brains to identify patterns and make predictions. It prevents you from overreacting to short-term trends and fads.
Invest automatically every month in an index fund. If you want to build an emergency fund, set up an automatic payment into a separate bank account, liquid fund, or any other place where you can access it easily.
If you buy stocks, make a rule to buy on a specific day at a specific time every month or every week. Have a “When to Sell” checklist and stick it near your computer so you can see it while transacting.
Creating a checklist and putting it in a drawer doesn’t work. Believe me.
To minimize the chances of acting irrationally, you have to have your eyes on the checklist when you are tempted to act, and then let the prefrontal cortex put some sense into you.
Just automate your investing and make it difficult for yourself to *undo* it. How?
Add some positive friction
We can’t change the way amygdala works. So, we have to limit its exposure to things that stimulate it.
We know that the more frequently we check the stock tickers moving up or down, the more tempted we get to act. Add friction that discourages harmful actions.
Uninstall apps you use for checking stock tickers every few hours. Uninstall the mutual fund apps to discourage yourself from taking action at whim. Stop watching business TV channels.
Tell your friend or spouse that you won’t check your portfolio more than once or twice a month. Ask them to hold you accountable.
Make it just a little bit more difficult to dip into your emergency savings or sell your investments.
Keep a journal of your investment decisions
I’ve found that writing down my investment thesis in a journal builds a good defense against my emotional volatility.
When your amygdala tells you to hit the Sell button, you can pick up your journal to remind yourself why you invested in a company in the first place. Also look at your ‘When to Sell’ checklist to see if you have at least a single good reason for selling.
The journal is not just a tool against your emotions. Over the years, it also helps you understand your thought process and evolve as an investor.
God! Too much of rambling. I need to stop now.
Signing off. But do subscribe to my newsletter.
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Nobody can be certain about the future. We are at best dealing with odds and probabilities, which will not always be in our favor. We cannot fully avoid risk and regrets.