Tame the chimp: how Stoicism can help us in stock market panics

The Stoic philosopher Epictetus told his students that the wise man “keeps guard against himself as his own enemy, and one lying in wait for him”. This is a view of human folly shared by the rather younger field of behavioral economics. As James Montier, behavioral economist and member of GMO’s asset allocation team, puts it: “Your worst enemy when it comes to investment is yourself.”

Behavioral economics has been a field of study since at least the 1970s, but it rose to prominence after the bursting of the dot-com bubble in 2000, particularly when Daniel Kahneman, one of its leading thinkers, was awarded the Nobel Prize for Economics in 2002. Today, many banks and asset managers now have in-house behavioral economics specialists, and quant teams who claim to run behavioral finance models.

The central idea of behavioral economics is that classical economics is based on the mistaken assumption that humans are perfectly rational calculators of their own utility. In fact, in the words of Dan Ariely, professor of behavioral economics at Duke University and the author of The Upside of Irrationality: “We are more like Homer Simpson.”

Our minds are capable of rationality, according to behavioral psychology, but are usually on auto-pilot, driven by rapid, emotional and automatic responses.

Jim O’Shaughnessy, chief executive of O’Shaughnessy Asset Management and a fan of behavioral economics, says: “Our rapid emotional response system — of fear, greed, hope, and so on — served humans well when we were struggling to survive on the Serengeti. But in the complex environment of the 21st century market, it leads many investors to do exactly the wrong thing at exactly the wrong time — to panic and sell when the market is bottoming out and to get greedy and buy when the market is peaking.”

Behavioral psychologists believe many of the mistakes investors make come from illogical thinking. We process information quickly and badly, which leads us to make poor decisions. Behavioral economists look for the typical mistakes — or ‘cognitive biases’ — that humans make when interpreting information and making decisions.

The list of such mistakes is seemingly endless. There is the confirmatory bias, whereby we seize on evidence that supports our beliefs, while ignoring evidence that conflicts with it. There is the anchoring bias, whereby we become emotionally attached to the price at which we buy an asset, and hold on to an investment in the hope it will eventually rise above this price, even if it is clearly heading south.

There’s the authority bias, whereby we tend to believe information that comes from authoritative sources, like the Federal Reserve, for example. There’s the attention bias, whereby investors tend to buy stocks that were recently mentioned in the news — regardless of whether the news was positive or negative.

But what practical help is the knowledge of these biases?

Fund managers and wealth advisers can use the theories behind behavioral economics to better understand their client’s typical emotional responses to investment. They can then tailor products that attempt to counter-act known biases.

Greg Davies, head of behavioral finance at Barclays Wealth, says: “We do psychometric tests to see how emotional a client is in investing. If they’re very emotional, and tend to over-react at the top and bottom of the market, we suggest using products that provide short-term smoothing, to eliminate short-term volatility.”

Mr. Ariely says: “The great hope of behavioral economics is that learning about these biases will make us less likely to fall into them, and capable of more rational decision-making.”

Other behavioral experts believe this may be hoping too much. Gerald Ashley, managing director of the risk consultancy St Mawgan & Co, and the author of Financial Speculation: Trading Financial Biases and Behavior, says: “It’s not certain that you can train yourself to overcome these biases.” Mr. Montier of GMO says that most investors acknowledge that such biases exist, but only in other people.

And yet there are some simple ways investors can try to defend themselves against their own folly. One is to trade less.

Terrance Odean, professor of behavioral economics at the University of Berkeley, says: “We’ve shown in a study that investors who trade more actively tend to do less well than more passive investors.” This is probably, Mr. Odean argues, because active investors, who check their portfolios every day have more emotional, instinctive and short-term reactions to market volatility.

Time to Reflect

You might also want to read less. Investors are bombarded with information, with highly emotive market ‘noise’, which can actually make it harder to make sensible decisions. James Montier suggests creating moments of monastic silence, in which one quietly reflect on one’s investment strategy.

It may also make sense to try to set an investment framework — a set of rules that you adhere to even at times of investment angst. Sir John Templeton, for example, put standing orders on stocks in advance, telling brokers to buy them when they hit lows and sell them when they hit highs. He gave the orders in advance because he knew he wouldn’t have the will-power to make the orders when the market was either panicking or rejoicing around him.

You can also set checks on your own impulses. Professor Odean says: “Electronic trading has made investing a lot quicker and more seamless. But this is not entirely a good thing. Friction and obstacles can be a good check on impulsive behavior. Investors can create these sorts of checks for themselves, like speed bumps.”

Mr. Davies at Barclays Wealth says: “A good metaphor is Odysseus and the sirens. Odysseus knew that, when his ship was sailing past the sirens, he would be unable to resist their song. So he had himself tied to the mast, and stopped up his sailors’ ears. He took steps in advance to curb his enthusiasm.” Pursuing a siren-resistant investment strategy could be as simple as, for example, only allowing yourself to take investment decisions once a month.

Finally, investors should be skeptical of any experts who claim to be able to predict human behavior too accurately. And that includes behavioral economists. There’s always the danger that behavioral economics will itself become the latest dogma, or the latest science used to dazzle credulous investors.

Dan Ariely says: “Classical economics captures some of human behavior, but not everything. Behavioral economics points out that some aspects of human behavior are missing, and they try to supplement classical economics with that missing component, to make it more accurate.”

Behavioral economics may be a useful field for predicting and counter-acting our own individual biases, but it’s not clear how useful it is as a macroeconomic forecasting tool. Perhaps, at least, it teaches us to be suspicious of all such forecasts.