Anyone who has read the basics of investing knows that the secret is to buy low & then sell high. Sounds simple enough right, but over and over again we do the exact opposite. Why? There are plenty of investing scams. When we read about them in the news we are surprised that people can’t see through such obvious scams, but throughout our lives we fall for different scams ourselves? Why?
In the image below there are two bowls. You are shown the contents of the bowls initially and then both bowls are shielded from view. You can no longer see the balls inside. Your aim is to pick a red ball. You can choose to draw from ONE of these bowls. Which bowl will you choose?
This experiment was conducted at MIT and most people who participated chose to pick a ball from the bowl containing a hundred balls. Even though the participants logically knew that they were more likely to pick a red ball from the 10 ball bowl (probability of picking a red ball = 10%), they still preferred to try their luck in the 100 ball bowl (probability of picking a red ball = 5-9%) just because they can see a lot of red balls in that bowl.
Let’s take another very commonly seen optical illusion.
Which line is longer? If you have already seen this illusion somewhere else you know the answer. The two lines are equal in length but even after seeing the proof, it is hard to convince ourselves of this.
Why? Because we have two brains.
Man with two brains
We have a reflexive brain and a reflective brain. The reflexive brain acts as a gatekeeper while the reflective brain thinks. Some people use one more than the other, but we all have and use both. When you are driving, your reflexive brain is the one that alerts you and makes you hit that brakes when there is an obstacle in your path. When you are doing a calculation, the reflective brain kicks in.
Simply put, your reflexive brain feels, while your reflective brain thinks.
Most of us, when investing, use our reflexive brain excessively when it should be the reflective brain that is doing the heavy lifting. For example, let us look at 2 common scenarios where we make bizarre decisions.
- Gold prices are going up. You decide it is the right time to buy, because gold is doing so well!
- The stock market is heading downhill. You panick, decide to sell everything and stay away for a while, with the intention of getting back in when the market bounces back.
You acted on visual cues, pretty charts, emotions and adrenaline. If you had let your reflective brain in on the action, it would have cautioned you about the discrepancies in the data.
Does that mean you should always use your reflective brain when making financial decisions? No. The reason is simple – you can never have all the information for the reflective brain to make the perfect decision. There is always that one piece of data that makes a difference and people using the reflective brain alone can’t see the forest for the trees, which would again cause them to miss many opportunities.
Investing Basics : What is the best way to invest?
You have to use both your reflective and reflexive brain at the right time and with the right balance. It might sound impossible, especially with the double headed irrational monster we are talking about. But we can trick the brain into making rational decisions. The secret is to have a plan and to know yourself.
To balance the reflexive brain
- Create some passive barriers (go for a walk before you buy, take a cold shower to overcome the emotion)
- Always ask a second question. I got this neat little idea from the book “Your money & your brain“. For example, you see a chart like the one below. You see that the company is performing well and the stock price is on an up slope, so you want to buy the stock. First, ask why. You might come back with – well it is a growing stock. Ask a second follow up question – how do you know it will continue to grow? Now do you see the problem with the answer to your first question? You answered the question “what is happening to the stock now” you don’t have enough data to answer the question what will happen to the stock in the future. For that you have to use your reflective brain.
- Instead of proving how an investment is a good purchase, try to disprove it. This is a good exercise to expose the holes that you might have overlooked when trying to convince yourself to buy.
- Have a partner/friend who does not have the same emotional habits as you and run your decision by him/her.
To balance the reflective brain
- Accept that you do not know everything.
- If something is too good to be true, it probably is.
- Even if the numbers look right but something doesn’t feel right, don’t be in a haste to make a decision.
To put these into practice, have a checklist of things you have to go through every time you make a decision. A series of questions about you, the market, the company and the fund will help you trick your brain into making a good decision for you.