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Why Investors Are No Better Than Lab Monkeys

By Mark Ford, founder, The Palm Beach Research Group
Wednesday, April 12, 2017

Every wealth builder should know one thing...
When the outcome of an investment depends heavily on some expected future event, it is inherently risky. When that anticipated event comes with a time frame, the risk is exponentially greater.
The good news: You can shorten those odds by being rational.
The bad news: Your brain is wired to respond to investment opportunities in irrational ways...
Many studies have shown this. One of my favorites was conducted at the UNSW Business School in Australia by Elise Payzan-LeNestour.
She tracked the decisions of investors given speculative opportunities. And then she compared their behavior with the responses of lab monkeys.
The monkeys were presented with two levers. One lever always dispensed a small amount of sugar. The other lever sometimes provided double the sugar, and at other times gave an electric shock.
Time and time again, the monkeys took the gamble. They ended up with lots of shocks and less sugar than they would have received from the safe lever.
The same pattern was evident with the investors...
When given the choice between risky investments that offered high returns and safer investments with lower returns, they favored the risk. As Payzan-LeNestour put it, "Investors pick pennies in front of steamrollers because they overlook the possibility of a loss."
When it comes to choosing safe investments, Payzan-LeNestour concluded that investors are no better than lab monkeys.
I've made my share of monkey-brained investments in my life. And almost every one of them involved speculation – the anticipation of some future event with a specific time frame...
My first real estate investment comes to mind. When my wife and I were beginning our family in Washington, D.C., our landlord came to me with a "fantastic" moneymaking opportunity.
She showed us charts and graphs illustrating how local real estate prices had risen for years with lines projected into the future. She also gave us lists of facts that seemed to prove a continuing bull market in property.
According to her calculations, I would double my money in less than three years by buying one of her properties. Knowing nothing about real estate at the time, I acquiesced. I invested about five grand, which was the entirety of our savings at the time, and waited expectantly.
You can guess what happened.
The market went the other way. I quickly lost my $5,000 and continued to lose money as property values tanked. It took me several years and $30,000 to dig myself out of that hole.
Here's another example: I was a member of an informal group of investors for about a dozen years. These were all investment insiders and experts – business owners, specialists, analysts, and financial gurus.
Every so often, one of us would bring something to the table. They were always speculations. But they were within the scope of the expert's knowledge, so they all seemed like good bets.
How did we do?
I like to say that our track record was "perfect"... We lost 100% of our money on every deal.
When it comes to investment opportunities, most of us do not act rationally. Here's why: Neurobiologists say the human brain is really an organic network. Some parts of the brain do the rational thinking, while others facilitate our emotional and primitive instincts.
Emotional intelligence can be extremely useful. And we sometimes make good decisions when our rational conclusions, emotional impulses, and primitive instincts line up.
But to make good decisions consistently, you must tamp down your primitive instincts... the part of the brain that always goes for more sugar and ignores the possibility of loss.
And the best way to do this, when it comes to investing, is to adhere to rules of engagement that reduce risk.
I've developed three such rules:
1.  Don't invest in anything you don't understand.
The challenge is that it's sometimes easy to convince yourself that you understand something when you don't. But you must know the business inside and out. You must know how it makes money, which products are most profitable, what particular problems it faces, what sort of financing it needs, etc.
2.  Never invest a lot of money in any single asset.  
When it comes to stocks, this is called "position sizing." You might say, for example, that you will not spend more than 5% of the money you have allocated for stocks on any particular stock, or no more than 1% of your net worth on any particular stock.
3.   To reduce risk further, always diversify your investing across a broad range of asset classes.
This is called asset allocation, and some studies suggest it is the single most important factor in acquiring long-term wealth.
These rules are what prevent my monkey-brained instincts from getting the better of me. And they will help you do the same.
Mark Ford

Further Reading:

Despite what the financial industry may tell you, it takes more than stocks and bonds to build wealth wisely. In his essay, Mark gives readers a "bird's-eye view" of the portfolio that has grown his wealth for more than 30 years. Learn more here: How to Break the Shackles of the Financial Industry.
"It is still possible for ordinary, wage-earning Americans to become wealthy," Mark writes. If you're impatient with scrimping and saving, this practical money-making strategy might be for you... Learn more here: The Three Ways to Get Rich.

Market Notes


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