“What is necessary to change a person is to change his awareness of himself.”
“The final mystery is oneself.”
If you’ve ever taken one of those online financial assessments, you’ll know that you’re asked questions about yourself. Most of them are either demographic – how old are you, are you married, etc. – or they’re financial – how much do you earn, how much do you have invested, when do you want to retire, etc. However, there are a couple of questions that are designed, supposedly, to help you measure your risk tolerance.
How would you perceive a 20% drop in the stock market?
I like for my portfolio to be aggressive/conservative/random choices.
All of these questions are designed to help an advisor determine just what sort of asset allocation you should have. If you’re risk averse and would run for the hills at the first sign of a downturn, then you should have a more conservative portfolio. If you’re risk-seeking and liken your portfolio to the thrills you get from jumping off of the Stratosphere in Las Vegas, then you may want to invest in all penny stocks (I am not recommending this course of action, for the record).
These risk questionnaires make two fallacious assumptions about your own knowledge of and mastery over Monkey Brain, what I call your limbic system.
- You know thyself as well as you think that you know thyself, and
- You should adjust your investments for your own behavioral biases rather than for time-tested quantitative reasons.
In this article, we’ll see why both are fallacious assumptions.
The Hot-Cold Empathy Gap Does Not Mean That Your Head is in the Oven and Your Feet Are in the Freezer
Have you ever known anyone who has thought to themselves before heading off to the morning work commute:
The first person who cuts me off is going to get run off the road and then I’m going to threaten that person with bodily harm!
Nope. It’s normally something like
I hope I get to work on time.
Yet, road rage is now a piece of our common vernacular because people, in the heat of the moment of getting cut off, do crazy, stupid, and often illegal things.
In simple terms, what happens is that we hit a stressful situation, and our brain tells our glands to start pumping cortisol, which serves to put the rational, Thinking You to sleep while giving Monkey Brain the equivalent of a triple espresso Red Bull shot.
Amped by the fight or flight syndrome, Monkey Brain makes decisions that make him feel good in the moment, but will give Thinking You, your prefrontal cortex – the rational, thinking part of your brain – a heck of a hangover once things settle down.
Yet, if you were to take 100 convicted criminals who had crimes associated with road rage, provided them a questionnaire a week before the crimes, and asked them to answer:
If someone cuts you off in traffic, are you more likely to
a. Curse but continue driving to your intended destination
b. Chase them 20 miles, pull out your tire iron, and bludgeon the person to death
you would likely get 99 a) answers and 1 b) answer.
The reason for this inability to project how we’ll respond in high-pressure, high-stress, or high-arousal situations is called the hot-cold empathy gap. Duke’s Dan Ariely studied the phenomenon as it related to sexual arousal. He and his team asked different questions about moral decisions and showed the respondents either non-provocative pictures (elderly people, kids, animals) or provocative pictures (scantily clad people in suggestive poses).
When aroused, people were more likely to take risks and otherwise adjust their behaviors versus the people who were in unaroused states.
Put another way, if you’re sitting in your house or in your cubicle in a calm environment, you think that you would act one way, but when you’re in the heat of the moment, you’ll probably act a different way. It’s why sports teams and the military go through so many drills – to get people to act just the same in a stressful situation as they do on the practice field.
It’s also why asking you how you’d react if the stock market dropped 20% tomorrow is a waste of time. Unless you’ve personally experienced a stock market drop in your same personal circumstances as now, it’s just a hypothetical exercise. Thinking You is answering the questionnaire; however, it’s Monkey Brain who is going to take over at the helm and cause your reactions.
But, let’s say that you know exactly how you’d react in a stressful situation. Does that mean that you should take action?
Remember, dollars have no emotions on their own. A dollar is still a dollar and still buys the same amount of goods and services no matter how you feel about it.
A lot of the behavioral psychology of money, and why I talk about Monkey Brain so much, is to get people to act the same way regardless of their emotional states. Invest SAFEMIN. Withdraw SAFEMAX. Don’t flush money down the toilet by paying outrageous fees and commissions.
However, in tying emotions to stock market swings, we run the risk of encouraging one of the most deleterious investor behaviors possible: market timing.
As we saw in “Herd Behavior Hurts Fund Investors,” market timers underperformed the market by 35.67%, meaning that they bought high and sold low.
Furthermore, as we saw in “Peak to Peak Investing, or I’m Afraid of Investing at the Top,” people who panicked and got out of the market at its last peak lost out on an over 10% annual return compared to those who value cost averaged.
Fear and greed will kill your portfolio. It will make you sell when the market is down and buy when the market is up. You’ll convince yourself that you will be able to control your impulses because, after all, you said that you could on the risk questionnaire, but when a wild gyration happens, your thinking self will hand over the trading account to Monkey Brain to go wild.
What’s the solution?
Have a plan and stick to it.
Yes, it’s that simple. You may think that you know yourself, but the reality is that very few of us know how we’ll react in high-stress situations that we’ve never seen before. The best approach is to create a plan that prevents you from letting Monkey Brain take over when he sees a shock headline (and the media would never use a shock headline, would it?).
You might think that you can put Monkey Brain in a strait jacket when times get tough, but do you really want to risk your financial future on that ability? I know I don’t.