The Dividend Letter: How to stop making investing mistakes: Rewire your brain
As investors, we don’t generally like to admit this, but we make mistakes. The issue is not the mistakes themselves, rather that they happen systematically, and that this results in mispricings in the market. While mispricings create opportunities for investors, it can be difficult to realise the benefits.
Most mistakes are behavioural. As humans, our behaviour has evolved over thousands of years, making it difficult to break free from nature’s programming. Recent research has shown that our brains are plastic 1 meaning that we can make physical changes to our brains in order to override some of our worst pitfalls. Brain plasticity has shown to help stroke victims as well as treat a range of mental health issues.
At Kempen, we believe that what can help stroke patients can also aid us as investors. However, in order to rewire our brains, we need be aware of when we make mistakes, correct the faulty logic and replace it with rational thinking. This is a challenge – in investing, the notion of becoming perfectly rational is impossible, but we can improve by correcting the most common pitfalls.
We believe the most common pitfalls are an overreaction to news, an aversion to uncertainty and herd behaviour.
Overreacting to news
In general, people assign more value to recent information than the distant past. From an evolutionary perspective, this makes sense: running away from immediate danger would save your life, whereas thoughtful contemplation of the long term consequences of running away instead, would likely not have the same result. In the context of financial markets, we tend to overvalue the importance of short-term information, which can lead to markets overreacting to short-term data 2. A good example is a company issuing a profit warning. Negative news comes out, and our tendency is to run, just like in the previous example. This tendency, however, creates opportunity as the market becomes overly worried about the prospects of a company. As an investor, buying a portfolio of these types of companies can result in long-term returns significantly better than the market. Executing on such a strategy is more difficult, however. We believe the best way to overcome ourown behavioural bias is to focus on long-term information, which puts the profit warning into context. Often a profit warning is seen a permanent mark on a company’s profitability, where in reality it is often only the result of fluctuations in the business environment.
By focusing on the long-term value of the business, it can be possible to benefit from a profit warning. Over time, this can rewire your brain to be less susceptible to short-term information. While overemphasising short-term information is bad, it is worsened by our aversion to uncertainty.
“While accepting that uncertainty in nature was not a good strategy for survival, it can be in the stock market.”
Our brains evolved in an environment where uncertainty did not pay off. Acting on every threat, whether real or not, increased your chances of survival. This resulted in an aversion to uncertainty. While accepting that uncertainty in nature was not a good strategy for survival, it can be in the stock market. The market discounts uncertain outcomes, and assumes that every perceived threat will become reality.
This results in an uncertainty premium, which is difficult to exploit, but not impossible. In order to do so, you need to accept that some outcomes will be negative and therefore diversify across different companies to capture the uncertainty premium. Combining diversification with a margin of safety means that your actual risk of losing money can be low. Buying stocks at a large discount to their fundamental value gives investors room for error in case the outcome is negative. If a stock is cheap enough, a negative scenario may still result in a positive return.
By consistently applying this framework, we can become adapted to accepting uncertainty. Our brains learn that the overall outcome is better than sticking to more seemingly certain results. Uncertainty is difficult to accept, and is intensified by our last behavioural pitfall, herd behaviour.
Another logical strategy from an evolutionary perspective is herd behaviour, as survival was higher in groups, which made us more comfortable acting together instead of alone. Our behaviour in stock markets reflects this legacy. We prefer to buy the stocks that are popular, the ones that everyone’s talking about and tend to avoid what has done poorly. Doing the opposite is emotionally challenging because it can feel lonely, although contrarians make a feature of going against the crowd. This creates mispricing as the crowd overprices what is popular and underprices what is not. At Kempen, we see group behaviour as one of the reasons the value premium has existed for as long as it has. We believe the best antidote against financial groupthink is to understand past cycles. By reading about past cycles, we learn that history really does repeat itself 3.
Other than understanding financial history, we believe anchoring to intrinsic value helps to reduce groupthink. By focusing on the fundamental value of the business, the crowd has less impact on your decision-making.
In conclusion – rewiring our brains
Contrary to popular belief, our brains are plastic. This means we can rewire our brains by consistently applying a more rational thought framework. As investors, we can apply brain plasticity with the aim of reducing the number of mistakes we make. By focusing on long-term information, accepting uncertainty and anchoring to intrinsic value, we believe many of the biases can be reduced.
Norman Doidge, The Brain That Changes Itself: Stories of Personal Triumph from the Frontiers of Brain Science (Penguin, 2008).
- Werner F. M. De Bondt; Richard Thaler, ‘Does the stock market overreact?’, The Journal of Finance, Vol. 40, No. 3, Papers and Proceedings
of the Forty-Third Annual Meeting American Finance Association, Dallas, Texas, December 28-30, 1984. (Jul., 1985), pp. 793-805.
- Norman Doidge, The Brain That Changes Itself: Stories of Personal Triumph from the Frontiers of Brain Science (Penguin, 2008).
This document is prepared by the fund managers of Kempen (Lux) European High Dividend Fund and Kempen (Lux) Global High Dividend Fund (‘the Funds’), managed by Kempen Capital Management N.V. (‘KCM’). The views expressed in this article may be subject to change at any given time, without prior notice. KCM has no obligation to update the contents of this article. As asset manager KCM may have investments, generally for the benefit of third parties, in financial instruments mentioned in this article and it may at any time decide to execute buy or sell transactions in these financial instruments. This article does not contain investment advice, no investment recommendation, no research, or an invitation to buy or sell any financial instruments, and should not be interpreted as such. This article is based on information that we consider reliable, but we do not represent that it is accurate or complete, and it should not be relied on as such. The views expressed herein are our current views as of the date appearing on this article. This article has been produced independently of the company and the views contained herein are entirely those of KCM.