The Atlantic reports on another study showing that financial experts do no better than the rest of us when it comes to making investment decisions. The nice part about this study was that the researchers examined how investment managers’ personal portfolios fared compared to non-experts of similar demographic backgrounds.
Why do experts fail to outperform the rest of us? Like it or not, our brains (and guts) are the result of millions of years of evolution. The sentiments that we feel and the shortcuts we take are adapted from long ago (humans only emerged about 100,000 years ago) and far away.
As evolutionary psychologists Tooby and Cosmides noted, the environment in which our ancestors grew up was like a camping trip that lasted a lifetime. Just as our eyes aren’t adapted to see infrared because that capability didn’t offer a survival advantage for our forerunners, so we aren’t wired to be great financial decision makers.
What did work well for us in the past were quick twitch, instinctual behaviors. These behaviors generally rely on three shortcuts (or heuristics):
- Avoid losses. We work harder to avoid losses than to pursue gains.
- Focus on the present. Our brains steeply discount future events; the result is that we tend to engage in behaviors that are rewarding in the present but costly in the future.
- Fit in with the group. We strive to be more like those in our tribe. We are also exceptionally sensitive to potential cheating.
These rules of thumb may seem a bit odd today, but in the risky, resource scarce environment in which our brains evolved, they probably worked very well. The challenge, of course, is that our environment has changed far more rapidly than have our brains. From an evolutionary perspective, our brains are still stuck in the past.
All of this causes our instinctual behaviors to lead us to outcomes that can be self defeating. We eat and drink too much, we sleep and exercise too little… and at times we make poor investment decisions. We shouldn’t be too hard on those investment advisers — they’re only human.
But what should we do? To the degree that we can, we should run the numbers, do the math, and keep our emotions and instincts away from our investment decisions. Specifically, Warren Buffet and others urge us to steer clear of active investment advisers and instead invest in low-cost index funds… and then to keep our paws off of them.