Evolution Makes Us Bad Investors

The idea of an “efficient market” is that all the available information out there is “priced in” to stock prices. This means that investors have no real way to gain an advantage.

But instinctively, we know this is not true. All you need to do is watch a stock drop 5% on an analyst downgrade or a tweet from the president, and the logic that this is all priced in doesn’t stand up.

One of the biggest arguments in all of investing is whether the markets are “efficient” or not.

The major reason why markets are not efficient is because ultimately, human beings make the vast majority of investment decisions.

As much as we would like to say that these decision-makers are rational and unemotional, the reality is that hundreds of thousands of years of genetic programming still govern our actions. These were responses that were developed to keep the human race alive… and they worked! It’s hard to override that with a couple years of business school.

The most powerful of these responses which impacts trading is called the “negativity bias.” This is a condition in which negative events have a greater impact on our brains than positive ones.

Research on human brain activity has shown that negative stimuli generates three to 12 times more physical (electrical) response than positive stimuli.

One famous experiment by economist and psychologist Daniel Kahneman had participants imagine either losing or gaining $50. Even though the amount was the same, the emotional response of those losing the money was larger. The negativity felt around losing something is much larger than the advantage of gaining something – even if it’s the same amount at stake.

This makes sense… For ancient humans, a good meal from a fresh kill would trigger a positive response and a full stomach, but falling off a cliff would trigger death and no more responses.

Earlier in human history, paying attention to negative stimuli was literally a matter of life and death. But today, it gets in the way of good investing…

One of the most common issues is to overemphasize the “negative” factor and miss out on great opportunities.

My favorite example of this is not buying a world-class business because of the valuation or some recent short-term disappointment.

In fact, our portfolio here at HX Trader is full of these kinds of opportunities. We look for great businesses with long histories of operational success and great stock price performance that have stumbled because of something that is immaterial to the value of the business.

Investors that have sold these stocks have overemphasized the negative. In many positions, we see companies that have beaten expectations on every metric but one, and the stocks tumble.

This is a prime example of negativity bias.

Another problem is when we dwell on negative events… even after they have passed.

I’ve fallen prey to this even in my own investing, where I would have a portfolio of 30 stocks but find myself spending 90% of my focus on the one or two losers in that group.

What was the last stock loser that you spent too much time on? Let us know in the comment section below.

Those stocks ended up being doubly dangerous because not only were they losing me money, they also prevented me from properly focusing on the rest of the portfolio. This resulted in missed opportunities, and – equally important – made me miserable.

This is one of the areas where well-managed stop losses can be even more important. We don’t recommend stop losses for every strategy and investment, but they are an important part of our trading strategy at HX Trader.

When I look back in my career, if I had instantly sold every stock that was down 20% from where I bought it, not only would I have saved a lot of money… I also would have been much happier.

Don’t discount the psychological impact that “losers” can have on your investing beyond just the money you’ve lost.

Check out Enrique Abeyta’s conversation with Whitney Tilson on the HX Podcast.