Fear, Greed and Your Brain

Wednesday, July 3, 2019 8,450 views

Jason Zweig, a columnist for The Wall Street Journal, offered his opinion on how humans are not hardwired to be good investors. In his book Your Money & Your Brain, Mr. Zweig dissects the human brain to discuss how humans are motivated to make decisions - mainly out of fear and greed. These emotions are valuable attributes for survival, but can become a hindrance when dealing with money. Specifically, Zweig states, "for most purposes of our daily life, your brain is a superbly functioning machine, instantly steering you away from danger while reliably guiding you toward basic rewards like food, shelter, and love. But that same intuitively brilliant machine can lead you astray when you face the far more challenging choices that the financial markets throw at you every day." Emotions such as fear or greed often trump our logic, especially when fueled by certain behavioral biases, and leading us all to the same conclusion – we are really not as smart as we think we are.

What causes us to have such poor judgment? Some of the more prominent behavioral biases include: regret avoidance, confirmation errors, familiarity bias, and irrational escalation.

Every year, DALBAR releases their Quantitative Analysis of Investor Behavior (QAIB) study, measuring the impact of investor behavior on investment returns. As this chart indicates, the return received by the average equity investor severely lagged both the S&P 500 and IFA's Index Portfolio 100. Apply dollar amounts to those percentages and it reveals the startling differences in accumulated wealth based on a starting investment of $100,000. DALBAR reports that psychological factors account for the bulk of this shortfall.

IFA's advisors help control those psychological factors. As much as we manage wealth, we also manage emotions to help investors stay the course. 

For detailed information on the hypothetical backtested performance data in The Dalbar Study: 20 Years of Average Equity Fund Investor vs. Indexes chart, including sources, updates and important disclosures, see ifabt.com. IFA Index Portfolios are labelled with numbers that refer to the percentage of stock indexes in the asset allocation, as opposed to the allocation of bond indexes. For example an IFA Index Portfolio 90 is 90% IFA stock indexes and 10% IFA bond indexes. The construction of IFA Indexes data starts in 1928 and introduces live mutual fund data of funds that are similar to the preceding index upon the inception date of the funds and uses that monthly mutual fund data up to the current month and are defined in detail at ifaindexes.com. Hypothetical backtested performance of IFA Index Portfolios assumes annual rebalancing of the asset allocation of the component IFA Indexes. The hypothetical backtested performance of the IFA Indexes and IFA Index Portfolios was achieved with the benefit of hindsight; it does not represent actual investment strategies for the entire period; and it does not reflect the impact that economic and market factors may have had on the advisor's decision making if the advisor were actually managing client money. The performance of index portfolios does reflect the deduction of 0.9% annual investment advisory fee, which is the maximum advisory fee charged by IFA, and mutual fund fees associated with the management of an actual portfolio over the entire period. Unless indicated otherwise, the performance of the IFA Indexes when shown individually, do reflect mutual fund fees, but not IFA advisory fees. IFA Indexes and IFA Index Portfolios were created by IFA in 2000. The S&P 500 Index is an unmanaged market capitalization-weighted index composed of the 500 most widely held, publicly traded stocks, whose assets and/or revenues are based in the US. The inclusion of information within charts and graphs relating to the S&P 500 Index is for informational purposes and shown as a comparison to other indexes, index portfolios or funds and as a general performance of large companies in the U.S. Past performance does not guarantee future results. Performance may contain both live and backtested data. Data is provided for illustrative purposes only, it does not represent actual performance of any client portfolio or account and it should not be interpreted as an indication of such performance. Study sources, Dalbar 2019 QAIB Study, Morningstar, Inc.

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