Unravelling the mysteries of our brain's role in investing

Our brain and its workings have fascinated people from all types of professions, from medicine to economics, from psychology to philosophy. While behavioural economics, as an academic field, started around the 1970s and 80s, in the 1700s Adam Smith was writing about the economic behaviour of individuals. Recent advances in our understanding of how humans make financial decisions have come from fields like psychology. There are 180 cognitive biases, many of which impact our investing approach.

The National Geographic Brain Games ran for nine seasons and it entertained viewers with experiments and findings on brain function and biases. Later seasons included celebrity guests like Jack Black, Ted Danson and Rebel Wilson. They dedicated an episode to money.

But as with most behavioural economics, it is the study and experiments into biases we see in other aspects of our life, like sports, that can provide extra insight into our approaches to investing.

One such basketball experiment stands out, that we think is pertinent to the current economic environment and it has to do with our responses to positive and negative feedback. This experiment has been repeated many times by sports psychologists, with similar results.

First, each subject takes 10 free throws. Each time the ball successfully goes through the hoop is recorded. This score becomes the baseline.

Naturally, scores range from zero to a perfect 10.

The next part of the experiment involves taking a few more shots but with two key variables. A blindfold and a crowd.

The crowd cheers loudly as if the ball went in upon the first blindfolded attempt. The shooter thinks they made the shot. This is repeated to erase the feeling that this may have been a fluke. Overcome by the positive reinforcement of a crowd. It is now time to see if the subject can best their baseline score.

Now, with positive reinforcement a low score is generally improved upon on the second attempt.

But what about the high scorers, the near-professional basketballers, who score high?

This time, the experimenters take a different approach. There’s still the crowd and a blindfold, but this time, irrespective of the result the crowd sighs at a ‘miss’.

You might guess where this is heading, but when the good basketballer takes his next 10 shots, they tend to score less than the baseline score.

What has happened in both experiments, according to Johns Hopkins University’s Sri Sarma, is attributed to the neuroscience of self-confidence. Those who received negative feedback, whose scores got worse started to doubt their own abilities and their brain created negative thoughts which had a negative impact on their performance.

Conversely, the positive reinforcement led to a calming influence on the brain, giving test subjects the confidence to improve.

What is interesting is that the positive experiment works almost every time. The results of the negative test vary, especially among professional athletes whereby some have been trained or have the capability to, in effect, block out the outside noise.

The point is, on both sides of the experiment, nobody’s skill or expertise is getting better or worse. Rather confidence has the influence to drive results.

Applying this to investing, investors need to be aware when they are getting negative reinforcement, it may just be short-term noise. Likewise, positive reinforcement should not encourage investors to take ill-considered risks.

Right now, as rates have been rising, there has been a lot of negative feedback about the economic outlook. At best, a slowdown is predicted.

Professional investors, like the basketball players, should be better at filtering this out.

For everyday investors, it's important to be aware of this feedback and be aware of its impact on your confidence.

Many investors missed the share market rally at the beginning of this year after their confidence may have taken a hit in 2022. Many confidence-hit investors also missed the post-COVID rally in 2020.

Nor should overconfidence encourage additional risk-taking or make you ‘fall in love’ with a trade because it did well. Assess portfolios, not on the recent past, but over your investment horizon or the long term.

Daily exposure to newspapers, books and online media with information about stock markets and bonds is accessible to everyone. In Australia, all working Australians are investors through the superannuation guarantee and their superannuation funds.

We think over time our superannuation system will continue to lead to superior long-term decision-making and active participation in markets by all Australians.

But it is paramount for investors to look past the ‘noise’ of positive and negative commentary and concentrate on long-term goals. Successful long-term investors survive through the economic cycle by sticking to investment principles that have withstood the tests of time, even if, for a short time it can be confidence-shattering. For portfolios, this may include better diversification. For equities, investing in profitable companies with strong balance sheets and stable earnings has historically given resilience to portfolios.

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