Psychology and Making Money
The Rational Investor
By Lightray on 12-27-2007
The goal of investing is to accumulate wealth.
However, the practice of investing is an exercise in cultivating self awareness. Knowing your own personality type and your how this effects your investing behavior can make the difference between sustained success and flaming out as you pursue your financial goals.
What does psychology have to do with making money? In short, almost everything. Most investing advice begins with something that tells you how to think about something. Changing your thinking requires an awareness of not only how you currently think, but an ability to be self aware, in the moment, to recognize unproductive thought patterns. Investing also requires mastery of the animal instincts—fight or flight—and their emotional manifestations—fear and greed. The emotions can have a strong impact on the outcome of otherwise objective, analytical judgment. Understanding how emotions color judgment can not only help you avoid cognitive errors, but also allow you to capitalize on such errors when they are made by others.
Through evolution, our brains are wired at the core (the amygdala to be exact) to respond rapidly to threats and opportunities. The amygdala triggers an emotional override of the rational brain because reflexes respond much faster than the slow process of cognition. Recognizing this mechanism and delaying a decision until the emotions settle and there is time for contemplation distinguishes the rational investor from the trader.
It is interesting that the amygdala also has a central role in memory processing. It ensures that memories associated with pain and pleasure are disproportionally burned into long term memory. This was an advantageous evolutionary adaptation when we needed to remember where the saber tooth tiger lived or where to locate food or a mate. However, this feature is a maladaptation when the brain is used to invest. It causes us to remember the painful loss on a bad investment far more than the steady, unexciting returns generated across the rest of the portfolio. In fact, psychological studies have proven that one dollar of financial loss is equivalent to three dollars of gain. Such asymmetry in psychological response to a quantitative event can create inefficiency in asset prices in times of crisis. Fortunately, we have the benefit of computers and historical datasets that represent a much better history of the facts than we can remember. However, it is incumbent on the investor to objectively look at the data and not bias it with their emotionally colored memories.
Recognizing the mistakes that our brain may create in the investment process is the first step in transcending its limitations. While the brain may not change in its physical form, we can reprogram it through the effort of conscious thought. With such mindfulness in practice, the rational investor can gain an advantage for accumulating wealth by recognizing opportunities that others do not. Being centered is the secret to buying low and selling high.
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Posted by sbeck2001 on Dec 27, 2007
I agree with bgrimes. Just thinking about finances makes me feel anxious. Listening to financial news doesn't help. How do I weight the different things I'm hearing? Is it more important that consumer confidence is high or that the Federal Reserve has lowered their interest rate or that the dollar is sliding into the Marianas Trench? Even forgetting the global market, I can't figure out where my money goes. Is my loss of money related to the discovery of more rings around Uranus (or is it Neptune?)? |
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Posted by lhall on Dec 27, 2007
Gee, if you transferred your money to almost any other currency you would probably be better off than the US Dollar? ;) |
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Posted by Keillan on Dec 27, 2007
Sound advice. One of the lessons that I've learnt while interacting with financial markets is to not let the ups and downs of particular securities dictate how one should invest. The rational approach would be to detach oneself from these pitfalls. It's so easy to make errors in a panic buy or sell situation, errors that can be financially costly. |
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Posted by TennisGuru on Jan 2, 2008
My brother moved to New Zealand about 10 years ago and at the time we all thought he was nuts. Well, today even their dollar is doing better than the US dollar and he is doing very well! But don't worry, there are plenty of 3rd world countries we can still travel to ;) BTW, a great blog is the Kirk Report, he asks $50 per year and it is well worth it. In general I have found two things that work; real estate in the SF bay area and a slow and steady investment strategy which means that you have to get started as soon as you can. |
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Posted by KatieFarmer on Jan 13, 2008
My Idealist husband and I have hit upon a solution that works for us. As a Rational, I see investing as long term and have little interest in day-to-day fluctuations once an investment decision has been. My dear Idealist cannot do the same. So, we max out my husband's contributions to his company 401K plan using no load stock index funds. My income takes up the any slack that may arise in our income in stream on a day-to-day basis and we have an agreement to make no changes without extensive discussion. This makes us both more comfortable. |
Basically good advice, Lightray. But at this point I'm feeling pretty panicked as I watch the dollar fall daily against every other currency. Do you have any advice? At the rate this is going, we'll never be able to travel outside the country again - and how will we afford imported products? Aggghhh, just writing this is giving me anxiety.