“Normal fear protects us; abnormal fear paralyses us.”
– Martin Luther King, Jr.
The core challenge as an investor is setting aside instinctive physiological and emotional responses at the root of our brain’s decision-making processes. Though they are perfectly suited to protect us from physical harm, they have little value in modern investing
Humans are not wired for disciplined investing.When people follow their natural instincts,they tend to apply faulty reasoning to investing
LESSONS FROM CHESS ABOUT OUR HABITS
“It is wrong to think of chess as an almost exclusively cognitive pursuit, where moves are chosen and positions understood only on the basis of mental patterns and inferences.” In reality, if you want to become a great chess player, or even a good one, “your ability to recognize and utilize your emotions is every bit as important as the way you think.”
Two of the most important executive functions are cognitive flexibility and cognitive self-control. Cognitive flexibility is the ability to see alternative solutions to problems, to think outside the box, to negotiate unfamiliar situations. Cognitive self-control is the ability to inhibit an instinctive or habitual response and substitute a more effective, less obvious one.
It is also important to resist the temptation to pursue an immediately attractive move, since that type of move often leads to trouble down the road. Teaching chess is really about teaching the habits that go along with thinking, Slowing down, examining impulses, and considering alternatives sounds reasonable
TRADING IS PSYCHOLOGICAL
Investing is psychological. And because we constantly want to protect our inner-being, we need to understand how to tame our impulses.
“The type of investor who is easily impressed by short-term performance is also really easily disappointed when a strategy struggles. It’s a personality thing. It’s what drives the behavior gap that Carl Richards talks about – getting into the next hot thing at a top and then getting out at a bottom for the hot thing after that, ‘repeat until broke.’” In fact, according to Paul Samuelson, “Investing should be more like watching paint dry or watching grass grow. If you want excitement, take $800 and go to Las Vegas.”
Prospect theory also explains the occurrence of the disposition effect, which is the tendency for investors to hold on to losing stocks for too long and sell winning stocks too soon. The most logical course of action would be to hold on to winning stocks in order to further gains and to sell losing stocks in order to prevent escalating losses.
In 1954, the limbic cortex was described by neuroanatomists. Since that time, the limbic system of the brain has been implicated as the seat of emotion, addiction, mood, and lots of other mental and emotional processes. It is the part of the brain that is phylogenetic ally very primitive. Many people call it “The Lizard Brain” because the limbic system is about all a lizard has for brain function. It is in charge of fight, flight, feeding, fear, freezing-up, and fornication
Controlling Lizard Brain
Investing is challenging enough without bringing emotions into the equation. Unfortunately, humans are emotional, and as a result investors often place too much reliance on their feelings, rather than using objective information to drive rational decision making.
What causes investors to make irrational decisions? The short answer: our “amygdala.” Author and marketer Seth Godin calls this almond-shaped tissue in the middle of our head, at the end of the brain stem, the “lizard brain” . Evolution created the amygdala’s instinctual survival flight response for lizards to avoid hungry hawks and humans to flee ferocious lions.
Over time, the threat of lions eating people in our modern lives has dramatically declined, but the human’s “lizard brain” is still running in full gear, worrying about other fear-inducing warning. Sadly, for many people, and investors, the emotional response from the amygdala dominates the rational reasoning portion of the prefrontal cortex. The best investors and traders have developed the ability of separating emotions from rational decision making, by keeping the amygdala in check
Well, the first thing you should do is turn off the TV. And by turning off the TV, I mean stop listening to talking head commentators, economists, strategists, analysts, neighbors, co-workers, blogger hacks, newsletter writers, journalists, and other investing “wannabes”.
LIZARD BRAIN AS OUR DNA OF DECISION MAKING
Amygdala also known as lizard brain control our decision making process of mind. In prehistoric time when human has to survive in wild without any protection of any kind ,nature equipped us with this apparatus in brain for our defenses and preferences.This is the seat of our instinctive reactions and reflexes in the face of dangers and stimulus.It saved us and makes us live our life.We can not grow beyond it as human and our habits are born here and stay as many of those instincts are crucial for our survival and normal life.It controls our life and decision making and always going to do so.One can not selectively decouple from this.But amygdala does help us to survive but it is unsuitable for profitable investment.Our natural instinctive reaction are invalid to survive investment and we are designed to fail.We are our lizard brain and can not evolve beyond it.As a result we have many common investment habits which most of us repeat.
Habits are impulses in trading and investment.Chess and trading share our common habits as we play both.We display same habits in chess and investment.Our habits depends on our personality and are different from person to person..So your personality type or psychological profile and risk profile matters both in trading and chess.
POSITIVE EMOTIONAL IMPULSES OR HABITS FOR REWARD PROCESSING
- Recency bias
- Performance chasing
- Disbelief in chart and patterns when they are most needed
- Exuberance and thrill in euphoria condition
- Applying hit and trial method-Chalta Hei
- Disposition to get tricked or spooked
- wide spread Amateurism. trading without skills and technical competency as hobby or recreation without competitiveness like part time electrician or computer technician with predictable bad outcome. Apparently hostile market environments where market conditions are always changing from volatile to stable and from trending to choppy so nothing works in all market environments for armature but can make sense to a technician
- These impulses are to be restrained by slowing down and contemplating alternatives
- Making move without any reason like in chess
- Keeping a piece hanging without protection as in chess
- Lack of capacity to wait and impatience .we forget that market trends only 20% time and 80% time drifts around.
- We tend to wait for certainty.
- Risk aversion-our preference for sure gain over probable gain.And we prefer probable loss over sure loss.we hang on to loss
- Our actions are not completely cognitive and consistent
- Fear of missing out
- Hoping in the face of hazard
- Framing effect on our mind and decision making
- Attraction to easy ways and temptations
- Attraction to easy and quick money
- Role of Our neural devices such as insular cortex and accumudin cortex which process rewards
- Habit of windfall gains making us more risk seeking due to high testosterone level
- Information impact in us.Our lizard brain has ability to distort the reality.Exposure to too much information make lizard brain highly active and distort the reality as per our psyche such created.Our lizard brain tend to magnify everything.and seek more excitements or intensifys fear and pain.which in turn control our decision making process
- We trade without plan and edge
- We trade on the basis of news and opinion of commentators -95% of whom arewrong
- Seeking happiness and joy to break away from boredom in trading instead of profit maximizing being secondary goal
- Our disposition to risk taking or gambling due to high dopamine level in brains
- Taking a long view means establishing a thoughtful plan and having discipline to stick with it through markets inevitable ups and downs .not to be guided by instincts, emotions aand lizard brain
- Like in chess it is important to resist the temptation to pursue an immediately attractive move .since that type of move leads to trouble down the line.Trading like chess is really about learning habits that goes with thinking.
- Impulses in stock market are like habits of chess .In absence of discipline or self control our habits rule us and our decisions.Its our lizard brain running the show in investing .
- We should be rationally maximizing profits and minimizing loss like in business
NEGATIVE HABITS AND EMOTIONAL IMPULSES IN RISK
1.Anxiety, Ego ,Fear, Panic, Depression of losses and their intensity of pain and our ability to tolerate them is our personality or risk profile.Their impact varies from person to person
2.risk aversion and preferring probability of loss instead of sure loss
3.Arguing with market.Fighting the trend.
Investing is about taming those impulses and removing emotions from equations of trading.
4.Grass is green beyond the wolf at the door
5.The Harmful Consequence of Brain on Pain
Besides forcing damaging decisions, another consequence of our lizard brain is its ability to distort reality. Behavioral economists Daniel Kahneman (Nobel Prize winner) and Amos Tversky through their research demonstrated the pain of $50 loss is more than twice as painful as the pleasure from $50 gain
6.Playing victim attitude to duck responsibility
7.Very short willpower to follow discipline to stick to a plan or a strategy
8.Cheating in market duty-common tendency to skip monotony and drudgery of regular trading duty to analyze ,read and track price and position at the cost of our freedom and time.
9.Not knowing what we don’t know.One is forced to second guess in the face of unexpected ,unforeseen and unfavorable outcome which only worsen.
We may be our master in normal times but mighty Amygdala is our master controller when it matters most.