Neuroeconomics provides a scientific explanation of why the vast majority of investors fall prey to the market cycle- and can’t resist it. Simon Mumme talks to director of UBS Wealth Management Research, Joachim Klement about the limits of active investing.
Joachim Klement, director of UBS Wealth Management Research, knows the lure of investment is based upon the physiological processes of the human brain.
When we invest, the region of the brain that generates excitement and joy, the nucleus accumbens, is stimulated by the expectation of financial gain.
It’s a powerful feeling: a small dose of cocaine will stimulate the nucleus accumbens in a similar way.
Klement calls this dynamic “dope and dough”, because investors become addicted to the excitement and anticipation of new wealth from their trades.
But the thrills can become troublesome as they often lead to high turnover in portfolios, particularly those managed by male investors, which usually results in lower performance.
For this reason, Klement recommends that active investing should be limited, even though the thrill of the chase ensures investors keep pursuing bigger returns and can be seen as ultimately positive.
But long after the adrenaline has faded and, as is often the case, expectations of wealth are unfulfilled, investors’ emotions turn against them.
When investments generate financial losses, the amygdale in an investor’s brain is stimulated. “You react with fear,” Klement says. “It’s the same as reacting to spiders and snakes – and when we’re afraid, we run.”
“We are all fearful after a year like 2008. These recessions are physiologically ingrained in our brain.”
These losses, however, will never fully temper the ardour that many investors succumb to again during the next bull market.
“In history, there has been an accumulation of [financial] crises about every 20 years, or every generation. But financial markets have a case of Alzheimers, and every generation of investors has to learn these lessons again.”
Klement points to a study by UBS Wealth Management that analyses the effectiveness of common professional traits exhibited by 69 day traders. Enthusiasm for investing among the traders contributed little to profit, while intuition and the ability to cut losses paid off a little better.
By a clear margin, the biggest contributor to median daily profit was discipline in the buying and selling process – in other words, effectively managing sensations flowing from the nucleus accumbens and amygdala.
Klement has devised a trading strategy, dubbed the 30/10 rule, for UBS Private Wealth clients to help them mitigate the ‘dope and dough’ effect.
For each 10 per cent fall in the index, investors are forced to shift a consistent sum of capital from their cash investments – say 5 per cent- into the equity market. After each 30 per cent rally in equities, investors must sell 5 per cent of their stock holdings and put the capital in cash. If the market momentum is upwards, the investor gradually sells down their portfolio. And if it falls successively, the investor must buy in at each 10 per cent interval, so they own more stocks when the market reaches its nadir.
Tested against the Dow Jones Industrial Average for the past century, the strategy outperformed in bear markets, but could not match the index during bull markets, generating a return similar to the benchmark, but with much less volatility.
So, for all the excitement and despair of active investing, the investors generated an index-like return.
But this is a far better return than those achieved by the average
US stock fund investor. Between 1985 and 2005, when the S&P500 posted a 12 per cent return, the average investor netted about 3 per cent. The true benefit of Klement’s 30/10 rule is that it prevents investors from becoming overly susceptible to their emotions and prevents them form selling down their portfolios in bear markets.
Locking in profits from investments is that simple. But only if following the rule were that easy.
“Education only works to an extent, because human nature is human nature,” Klements says, commenting on the habit of investors to learn their lessons again during each cycle.
When investors become excited by the prospect of financial returns, they act more riskily than if they were concerned or afraid. It becomes increasingly likely that they will commit a mistake by taking on too much risk.
Education, experience and constant reflection about investment can prevent potential mistakes, Klements says. Successful investors are disciplined, and employ caution in their approach, while maintaining enthusiasm for returns.
They make decisions with a calm mind, rather than in the heat of the moment.
Robin Miranda, a colleague of Klement’s at UBS Wealth Management, says studies indicate that people who lived through the Great Depression were traumatised by the experience.
After the economy eventually recovered and employment conditions improved, that generation prized financial stability and, when they had money to invest, they did not venture beyond cash or bonds.
“Traumatic memory is permanent; it is always lodged in the brain,” Miranda says. “This crisis isn’t there yet.”
She notes that the worst year of the Great Depression was 1937, near its end. If such a late-stage downturn occurred after 2008, the global financial crisis could become a traumatic experience for populations worldwide and potentially alter their attitudes to risk irrevocably.
“We’re very interested in risk and whether we perceive it properly in the information flows that we face.”
Klements, a physicist by training, says the nature of investment risk is as volatile as the weather.
“Both financial markets and the weather are non-linear, often dramatic and always changing. There are really big limits to forecasting them.”
And the major role played by emotions in our financial decisions makes modelling the movements of financial markets extremely difficult.
“Trying to model the moves of billions of people making financial decisions each day is way out of the box,” Miranda says.