I remember learning about Newton’s laws of motion in my secondary school.
Even at a tender age, I figured that Sir Isaac Newton must be a really smart guy. After all, everyone in my age cohort was dutifully studying his formulas.
However, later in my life, I learnt that a smart person is not always a smart investor.
According to Jason Zweig, a Wall Street Journal columnist and author of Your Money and Your Brain, the famed physicist lost a huge bundle while investing in the South Sea Company back in 1720.
The loss hurt Newton so deeply that he forbade anyone from uttering the words “South Sea” in his presence.
How your brain works against you
Zweig’s book is not about investing per se, yet it is one of the most pivotal books I have read as an investor.
Your Money and Your Brain touches a rarely-discussed area of investing, namely, the investor’s psychology.
Let me give you an example. Take the book’s chapter on predictions.
From Zweig, I learnt that the human brain has a tendency to recognise patterns.
Zweig goes on to make a key point that has stuck with me till today. The tendency for pattern recognition, he explains, happens automatically and subconsciously.
It’s uncontrollable, he concludes.
For example, when you look at a set of random numbers, your brain will start ticking without any prompting. A pattern is thus formed automatically in your head.
While this ability can be useful, the tendency can be detrimental to our investing well-being.
Investing gone wrong
Now, imagine this pattern recognition occurring while we look at stock prices daily.
Based on Zweig’s findings, your brain is likely to start processing the stock price movements and start sending out patterns and signals to your brain.
For instance, if we see three days of continuous stock market drops, our tendency for pattern recognition may draw a line between these three days and start telling our brains that the market is going to tank further.
This pattern might stir up fear in our hearts.
The problem, of course, is that the pattern that we are receiving (“the market will tank further”) might not be real.
But the subconscious fear can impact the way we invest.
Why psychology matters
When we are doing our homework on a company, we can be rational investors. We can be objective in evaluating a company because we can sit in a quiet room to study and reflect on our work.
Putting our work into action, is another matter though.
If we are not careful, daily stock price movements can have an effect on how well we execute our plan.
Pattern recognition can stir up fear or euphoria so strong that these emotions will overwhelm our rational minds, causing us to act in a manner that is inconsistent with our original homework.
To make it worse, when we invest, our hard-earned money is at stake. This factor adds further stress on our rational minds, thwarting us from making the right choices.
Get Smart: Awaken the Smart Investor in you
Good investors know that they need to focus on the underlying business of a stock.
But in practice, investors might get distracted by daily price movements. Even worse, some investors may be unaware of the impact that these flickering numbers can have on the way they invest.
For me, it would be a shame if we have put in the hard work to study a company, only to find ourselves unable to put our best-laid plans into action.
All because of the phenomenon of pattern recognition.
The above is just a sliver of what Zweig had shared in Your Money and Your Brain.
The author also talks about other psychological failings such as overconfidence and greed. Zweig also touches on interesting topics such as how humans perceive risk.
These are not random observations alone. Zweig often refers to scientific studies to back up his research on human behavior.
The book has helped me be aware of potential psychological biases. I would readily vouch that managing your bias is as important, if not more, as putting hard work into analysing companies.
And that is why Zweig’s book, which I read almost a decade ago, has been pivotal for my development as an investor.
The book is useful for you to identify and guard against psychological biases that stand in your way of putting your best investment ideas into action.
I know that it has been, for me.
Disclosure: Chin Hui Leong does not own any of the stocks mentioned.