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"In the back of the cab"

09 December 2015

David Lane, Partner and Business Development Technical Director

Behavioural finance, I suspect is not a subject that typically comes up with a cab driver driving through a part of the country that seemed to have an intimate meteorological relationship with Siberia. Outside was cold...very cold. But inside things were warming up as my driver ruminated on his disappointment, frustration and anger that a sure-fire investment had gone horribly wrong and that all or nearly all of his invested capital had disappeared with very little chance of ever returning. It reminded me of my friend (and yes it is a friend!) and some of the regretful (awful) decisions he has made over the years when an “investment opportunity” presented itself. Over the years he has invested in a company that made luxury handbags that vanished in a puff of well-intentioned smoke, a telecommunications company that similarly fell by the wayside, and finally more recently, an oil company that has also nearly gone the same way. In all these situations his decision-making lacked focus. In a way this is not surprising. In a book on behavioural finance Jason Zweig[i] makes the compelling point that when we make any kind of decision that involves money then “emotion overwhelm(s) reason” and that “financial losses are processed in the same area of the brain that responds to mortal danger”.

Emotion overwhelms reason

To illustrate this point let us return to my friend’s ill-fated oil company investment. It was a recommendation from his colleague who had invested earlier in the same stock and watched it rise as investor sentiment became increasingly positive. Initially his response was one of suspicion. His fingers had been burnt before and he, (at this point) showed a healthy scepticism whilst undertaking some flaky research, reading investor blog sites with the result that this scepticism started to turn into mild(ish) caution. Time passed and his caution transformed itself into growing confidence that this was indeed “the” investment and the share price would continue rising, defying market gravity. What an ingenious way to pay down the mortgage or pay for that exotic holiday for the family once his profits had been banked. Enthusiasm had started to slide into greed.

The investor “honey trap”

He was now immersed in what I would term the classic investor “honey trap” and he bought the shares. The share price continued its rise, confirming how annoyingly clever he was. He bought some more shares to emphasise that point. A few days later the price peaked and started to fall back. His initial reaction to my raised eyebrow was indifference. This was only a minor blip and the price would come back and reach new heights. But it continued to fall, a fact that he put to the back of his mind. He had entered a period of denial which seeped into something more serious. There seemed to be trouble ahead with investor sentiment starting to become increasingly pessimistic and bearish. His concern soon started to become fear. Should he sell and crystallise a loss or hang on? Sometimes with investing the real challenge is not necessarily when to buy but when to sell, and fear is not good a bedfellow to rational decision making. Remember Zweig’s point that my friend’s financial losses were now being processed by that part of his brain that responds to “mortal danger”. In the end he didn’t sell and has sunk into a form of despair over the share price, which has continued to fall and now shuffles along as a beleaguered penny share.

Removing the emotion

In making this investment my friend demonstrated the textbook symptoms of behavioural investing. His initial scepticism translating itself to over-confidence before turning to greed from which he managed to extrapolate a range of near impossible outcomes. On reflection I suspect this is partly why clients choose to work with Vestra. They want impartiality and objectivity and also to be protected from themselves in making bad decisions. There is no such thing as an easy investment. Returns have to be fought for with good research, experience and the ability to make the right decisions at the right time. It takes patience, discipline and a cool head to get right. In a way it is about taking the emotion out of making the big decision, a lesson that I think my friend and cab driver have now learnt.

[i] Zweig, J (2007) Your Money or Your Brain (Simon and Schuster) as quoted in Jason Butler Financial Times Guide “Wealth Management” 2015.