Friday 3rd April, 2020

 

It has been a relatively quiet week in markets, even though there have been some very sad and continuing fatalities, plus nasty economic numbers.

This week I am bringing you something different.

In investment terms, we are preparing for what we believe lies ahead – which, from an investment stance, is very exciting.  Much of that preparation is mental, not just number crunching.  Why?

The stock market falls which we are now midst, the so-called bear market, will typically finish with clear evidence of fear and some panic amongst investors.

On the one hand this means you should not buy risk investments (certainly not in scale) until there is clear evidence of that fear, even though right now you might be champing at the bit to jump in – well, one or two of you.

On the other side of the coin, when fear abounds you (we?) will feel extremely uncomfortable.  Yet that is when you must overcome your most basic instincts (run away!) and “buy”.

The problem is that we are simply not well designed to deal with uncertainty – at least not the sort of uncertainty we encounter in investment markets.

Our brains are superbly constructed to deal with the African savannah 200,000 years ago, or the threats from the wilderness which was Europe 50,000 years ago, variously populated by hippopotami, rhinoceroses, mammoths, elephants, and the sabre-toothed tiger.

But our brain isn’t so well adjusted to the industrial age, which began 250 years ago, and which began to turn the daily lives of our recent ancestors upside down.

And how about the “internet age” that we are now living through? You can be confident our brains aren’t designed to cope with this age of superfast and ever-changing news and data.  What our brains are designed for is to maximise our chances of survival as the world existed 50-200,000 years ago.

Our brain, let’s call it our old brain, learnt to take shortcuts, which meant it could respond rapidly to threats and improve the odds of survival.  It is fast, a “quick and dirty” system, which enables your brain to take shortcuts with very limited information.

This is my favourite example of the old brain in action (via the marvellous James Montier):

  • I place a glass box on the table in front of you.
  • Behind the glass walls, it contains a large snake.
  • I ask you to lean forward and concentrate on the snake.
  • Suddenly it rears up!
  • You WILL jump backwards.

That is your old brain in action. It will react very fast to keep you safe – even though the snake is behind a glass barrier.

This is what happened. When the snake moved TWO signals were sent to your brain:

  • One went on the fast road.
  • One went on the slow road.

The fast road is straight to the old brain which deals with fear and risk and uncertainty.

There is a threat, and uncertainty, and the old brain jumps into action rapidly, and forces the body to move backwards rapidly – without hesitation.

In contrast, the signal that went more slowly, to what we might call the new brain, processed the information more consciously and recognised that there was a layer of glass between you and the snake. The new brain is more rational, but slow.

But the signal from the new brain of no threat was too late, you had already jumped backwards.

From a survival point of view, if you had been on the savannah thousands of years ago (without the benefit of the layer of glass) this old brain function is fast and effective – and would have saved your life. You would have died if you relied on the (slow) new brain to figure what to do.

Remember, the old brain acted on limited information, because it means it can react more quickly to less information. Are speed of response, and these shortcuts, always going to be helpful in the internet age? Let’s see.

Consider this example in a modern context:

  • Imagine you are walking into a shoe shop
  • You have your eye on a certain pair of shoes, and the price is OK
  • Then they announce you can have it for half-price
  • A Sale has just begun!

Wow. How can you refuse!

Perhaps you will even buy two pair.

It doesn’t take the rational new brain long to figure that out.

In contrast now imagine:

  • You are visiting your financial adviser,
  • and you intend to invest a certain amount in a stock market fund.
  • He enters the room, and announces that share prices have halved.

What do you do?

You run a mile!

In the first example, instant happiness. There is no threat from a half-price pair of shoes! What you see is what you get.

In the second example, instant fear. Without a second thought.

What was going on?

When you buy an investment you literally buy future uncertainty.

An investment is bought in the hope that you can sell it at a higher price, to make a profit. There is no certainty that you will make a profit.

Unhelpfully from an investment perspective, our brain is designed, hard-wired, to react in a very distinct way when confronted with uncertainty.

When there is the sort of sudden price change we saw above, the future uncertainty is immediately crystalised, as if someone has just hit you over the head.

Our impulse, is to retreat – flight.

Flight means you survive, you live to fight another day.

In addition, if the price is falling sharply, a lot of investors are selling, doing the opposite of what you were considering. This instinctively makes you feel very uncomfortable. This is because you (and all of us) have a VERY strong instinct to herd – our experiences on the savannah taught us that to be in a herd brings safety.

As soon as you know prices have halved and the herd is running in the opposite direction to you, your very strong instinct is to join that herd, because it is safer.

The old brain still dominates your behaviour, even in this modern investment context. This is very unhelpful. So, a good starting point for your future investing success is to acknowledge that you have these unhelpful traits – because it will make it easier to adopt the solutions.

We are a bundle of hormones and instincts which don’t always sit easily together. Fear and greed are two powerful instincts.

When something suddenly triggers fear, it runs amok and tramples any prior confidence, especially any greed instinct.

Confidence persists for long periods, and builds slowly, but fear emerges fast, and triggers evasive action. In an investment context, this often means rapid, emotional selling and typically poor decision-making. Even if we don’t sell, this fear drowns out the new brain, and the possibility of a rational response to this new uncertain environment.

Today and the weeks ahead

In the weeks or months ahead, when there is clear evidence of panic, these might be some of the best, or THE best, investment opportunities of your life.

But many will not find it easy to act, for all of the reasons set out above – not just you, but most of us.

So in coming weeks we will continue to build out a shopping list, hopefully in a clear and measured way, which will act a bit like pre-commitment for when the moment comes to act.  Even then action does not mean throwing all your money at markets – there will be options for those of all dispositions.