Know Thy Risk

"Know Thyself." ~ Socrates (469-399BC)

Humans are not wired to be smart investors.  We are wired for simple, survival-oriented pattern recognition, which, financially speaking,  can potentially doom the average person to failure. 

This "wiring" has been referred to as our "primitive brain" or "rat brain," which prefers problem-solving "heuristics"-- mental shortcuts that link patterns to potential rewards.  These shortcuts and patterns were quite effective in aiding primitive man to find food and flee danger but arguably are counter-effective in modern man's flawed pursuit for higher investment returns.

Our brain's limbic system will recognize patterns and, where it has the potential to harm investors, can "trick" us into believing the pattern will continue.  This is where the disconnect between "real risk" and "perceived risk" occurs.  The broader the gap between the two, the more potential damage it can wreak on an investor's portfolio. 

For example, if a particular investment, or the market as a whole, is doing well, an investor's limbic system tells them it will continue to go up; the investor will tend to buy more stocks at higher prices; real risk increases; and the investor perceives risk to be lower. 

Conversely, if the investment or market is doing poorly, the investor's brain tells them it will continue to do poorly; they tend to sell into the weakness; and perceive risk to be higher when real risk is actually lower.  This behavior creates a "buy high and sell low" pattern -- the exact opposite of what we should do!

Simply put, a prudent investor must be capable of making rational investment decisions.  Otherwise, the human propensity to misperceive risk will dramatically increase the odds of poor investment decisions.  For this reason, I believe the real key to prudent investing goes back to what I consider the beginning of a rational investment process -- the centerpiece of western philosophy -- Know Thyself. 

Knowing yourself, in my view, is two-tiered:  You must first know yourself as a human, as we have already touched upon in this post, and secondly, as an individual.  As individuals, we are also "wired" with certain behavior biases and personality traits. 

I will not delve into genetics or environmental influences but, in general, an understanding of what we do well and what we do poorly is essential to success in all aspects of our lives.  Additionally, learning to identify behavior patterns and personality types of others is enormously valuable in maximizing our potential as individuals.

Obviously, a compulsive gambler, a worrier, or simply someone who has no interest in, or capacity to learn, matters of finance, should stay away from making investment decisions.  You may be well-acquainted with yourself already.  If not, I believe a good start is this online personality assessment based upon the Jung-Myers-Briggs typology. 

As for insights into human behavior and emotion, I highly recommend the books, Behavioural Finance by Montier and Emotional Intelligence by Goleman.

As we've witnessed over the past few months, greed will build on complacency and move markets to unsustainable highs followed by quick and dramatic "corrections" driven by fear.

The most successful investors are able to ignore the portfolio-wrecking emotions of fear and greed during market cycle gyrations and will have the uncanny ability to intuitively align real risk with perceived risk.  Of course, I believe the greatest investors are philosophers with a heightened awareness of their own limitations, both as humans and as individuals...

 

Comments

[David]

Great post, Kent.

What do they say, "The stock market is a very expensive place to find yourself"?