WE ARE DRIVEN BY EMOTIONS

1. Emotional decision-making is the default option for our brains. However, we all like to think that we only use logic to arrive at our decisions. In fact without emotion we would be largely incapable of making any decisions, but all too often we allow emotion to rule unchecked. Welcome to the human condition!
2. Neuroscientists have recently uncovered two particular traits of significance to investors. The first is that we are hard-wired for the short term. We tend to find the chance of short<term gains very attractive. They appear to stimulate the emotional centres of the brain, and release dopamine. This makes us feel confident, stimulated, and generally good about ourselves.
3. The second is that we appear to be hard-wired to herd. The pain of social exclusion (i.e. betting against everyone else) is felt in exactly the same parts of the brain that feel real physical pain. So pursuing contrarian strategies is a little bit like having your arm broken on a regular basis!
4. Self-control over these impulses is very hard. Psychologists have found that self-control is a limited resource. The more we use it, the less we have left to deal with the next occasion when self-control is required.
5. The good news is that we continue to make brain cells pretty much throughout our lives. And our brains aren’t fixed forever, we can rearrange the neurons (a process called plasticity). We aren’t doomed, we can learn, but it isn’t easy!
6. It is also worth noting that we are very bad at projecting how we will feel under the influence of emotion - a characteristic that psychologists call ‘hotcold empathy gaps’. That is to say, when we are relaxed and emotion free, we underestimate how we would act under the influence of emotion
7. Our natural tendency is to listen to people who agree with us. It feels good to hear our own opinions reflected back to us. We get those warm, fuzzy feelings of content. Sadly, this isn’t the best way of making optimal decisions. What we should do is sit down with the people who disagree with us most. Not to enable us to change our minds (because the odds are staked massively against such an outcome), but rather to make us aware of the opposite point of view. We should look for the logical error in the opposite point of view. If we can’t find such an error, then we shouldn’t be so sure about holding our own view as strongly as we probably do.
8. Our minds are neither supercomputers nor even good filing cabinets. They bear more resemblance to post-it notes that have been thrown into the bin, and covered in coffee, which we then try to unfold and read! However, we all tend to think of our memories as perfect, like picture postcards or photos. The psychological truth is that memory is a mental process. One input into that process is the truth, but it is certainly not the only, let alone the major, input.
9. Shefrin and Statman (1985) predicted that because people dislike incurring losses much more than they enjoy making gains, and people are willing to gamble in the domain of losses, investors will hold onto stocks that have lost value (relative to the reference point of their purchase) and will be eager to sell stocks that have risen in value. Effectively, they argued that people tended to ride losers and cut winners. This has become known as the disposition effect.
10. We have a relatively fragile sense of self-esteem; one of the key mechanisms for protecting this self image is self-attribution bias. This is the tendency for good outcomes to be attributed to skill and bad outcomes to be attributed to sheer bad luck. This is one of the key limits to learning that investors are likely to encounter. This mechanism prevents us from recognizing mistakes as mistakes, and hence often prevents us from learning from those past errors.
11. Our world is inherently probabilistic. That is to say, we live in an uncertain world where cause and effect are not always transparent. We have a habit of believing that we can control events far more than we can. Thus we attribute outcomes to our actions, even though such outcomes may well have nothing to do with us. The illusion of control is particularly prevalent when lots of choices are available; you have had early success at the task, the task is familiar to you, the amount of information is high and you have a personal involvement. Large portfolios, high turnover and short time horizons are the financial equivalents of these conditions.
12. we seem to be very good at accepting feedback we want to hear while not only ignoring, but actively arguing against, feedback we don’t want to hear.
13. Lao Tzu, a sixth-century BC poet, observed: ‘Those who have knowledge don’t predict. Those who predict don’t have knowledge.’
14. Confucius, who stated “To know that we know what we know, and that to know we do not know what we do not know...

SELF-CONTROL IS LIKE A MUSCLE

1. Under emotional distress, people shift toward favoring high-risk, high-payoff options, even if these are objectively poor choices. This appears based on a failure to think things through, caused by emotional distress.