Why Human Behaviour and Psychology affects Your investing decisions?
‘Be fearful when others are greedy and greedy when others are fearful.’
Warren Buffett
Are you Investing or Speculating and how to know the difference?
Humans are not always rational and are more driven by emotion than they realise. Think of some of your work colleagues or family members. Do they always act rationally? They are driven by different parts of the brain due to our evolution. When investing we need to understand which part of the brain is making the decisions. This is particularly important during market crashes when the fight or flight part of the brain can take over.
Think of the market as a person making different decisions depending on if they are happy or grumpy. Every day they offer you a price on businesses all depending on how he is feeling that particular day, rather than the actual worth of the businesses due to its fundamentals of earnings and assets. If they are being greedy they will charge more one day and if they are scared they will want to get rid of their businesses and will sell for much less. Human psychology and human emotion is really important to understand when investing. We can act very differently depending if you are happy or scared. It’s like having two personalities like the characters from the book (and film) Jekyll and Hyde.
It’s like the split personalities of Jekyll and Hyde. One day a perfectly rational person another day another a grumpy person.
The markets can often resemble the split personalities of Jekyll and Hyde
Can you trust that you are getting the right price for a business?
How many of your work colleagues, some of your family or maybe even your partner would you call rational? How everyone assumes that humans are rational. As humans, we are very much not rational. We do things for bizarre reasons. This is the same as markets. We act very differently in practice as we do in theory.
Most good investment decisions go against what you think would be a good decision. Investing is counter-intuitive. Often the right thing to do doesn’t feel like it at the time.
Mr Market’s split Personality
Mr Market is the best metaphor explaining how stocks become overpriced from Benjamin Grahams’s book The Intelligent Investor. Grumpy Mr Market does not value a product like a private buyer would. Is Mr Market still around today? Is he still grumpy? You bet he is.
Would you be willing to let someone come by your house once a day to tell you exactly how he was feeling and would you ever agree to do what he says depending if they were happy or grumpy?
To win in finances you shouldn’t ignore Mr Market but you should do business with him but only to the extent that it suits your interests. Mr Market’s job is to provide you with a price and your job is to decide whether it’s in your interest to act on it. You do not need to trade with him because he begs you to. By refusing to let Mr Market be your boss you transform him into your worker. The investor who permits himself to get worried by a market move downwards is turning his greatest strength to his greatest weakness.
There is a difference between investing and speculating. Investing is buying an actual living breathing business that over the long term will generate profits from selling their goods and services and you also expect to get your money back from this venture.
Speculating is much more short term where the aim is to get in and out of the market at profit, taking the value from the market. Speculating is trying to predict the moving of the share price.
Understanding psychology is important for investing. When investing it’s important to understand how our brain works. The latest theory is that the brain is made up of three parts called the triune brain model. This three-parted brain model is discussed in the book The Chimp Paradox by Professor Steve Peters.
This triune brain model means we can act emotionally especially with money. Money is a very emotional topic and it really affects the way our brains work. In different situations like a stock market crash, the brain will release chemicals into our brain to set us into a fight or flight mode. This would help us for thousands of years as that danger was often a real-life bear rather than just a bear market (when the markets crash).
Your brain controls the way you think and the way you think controls you.
The three parts of the brain are:
1) The reptile brain. This is the survival-oriented part of the brain. This is your fight, flight or freeze area of the brain. This ancient part of the brain has evolved over millions to keep us out of danger and alive. During a stock market crash, our reptile panic mode can often come out to play.
2) The computer part of the brain (limbic system). This is the functional worker part of the brain and see the world as a set of problems and challenges to complete. Being on autopilot is a sign you are in computer mode.
3) The rational human part of the brain (the Neocortex). Here is your planning mode of the brain and seeing the world as a more connected place. If you are ever inspired or working towards meaningful goals then you are in rational human mode or sometimes called entrepreneurial mode.
The three parts of the brain are: 1) The reptile brain 2) Your computer part of the brain 3) The human part of the brain.
Kahneman called this System 1 (Fast Thinking) and System 2 (Slow Thinking). He compared this to the emotional Homer Simpson and the logical Spock from Star Trek
The markets are made up of lots of people making individual decisions and not all of these are rational decisions. Benjamin Graham called this Mr Market having a split personality of either fear or greed, which means the price the market gives you on any one day, may not represent the fundamental value of a company. The markets often behave with a herd mentality
We, humans, are emotional creatures. Our emotions often make us do the exact opposite of what would be good for us long term. A falling stock market may cause us to panic and sell at a time when it would be actually better to buy. We may greedily buy into the latest fad trying to make our riches only to realise that we have only bought nothing but hot air. Our brains are not wired to be good investors. We have evolved over thousands of years and our ancient brains lead us to do things that don’t benefit us in our modern world.
‘Be fearful when others are greedy and greedy when others are fearful’
Warren Buffett
Do your emotions affect the way you use money?
Have you ever panicked when you see the stock market crash?
Are you investing your money or are you speculating?
This article is written by Neil Doig who is the author of Millennial Money Mindset: If you want the fruits you need the roots.
The book Millennial Money Mindset: If you want the fruits you need the roots is now available on Amazon in print, Kindle and audible to buy at the link below. Millennial Money Mindset: If you want the fruits you need the roots was shortlisted by the Financial Times and helps you save money, save time and reduce stress around money.
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Neil Doig is the Director of Money Tipps and is educating and inspiring better investing. Neil Doig is a Financial Times shortlisted author and speaker at WeWork in 2018 and Picturehouse cinema and the Feast Festival in 2019.
Money Tipps is an Education Technology company with the aim of making financial education simple, fun and achievable. Money Tipps educates and inspires better investing and aims to save you £1000s from paying expensive financial advice fees.
Money Tipps run investing accelerators in London and Oxford to help you make better decisions with your money.
