Behavioral Investing: How to Overcome Your Worst Instincts

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. Many investors know that they have behavioral biases, but may not know strategies to help overcome them. I'm here today with Steve Wendel--he's the head of behavioral sciences here at Morningstar with some of these strategies.

Steve, thanks for joining me.

Steve Wendel: Thank you so much.

Glaser: One of the strategies that you've talked about is trying to lock yourself in. What is this about, and why would investors want to do it?

Wendel: Exactly. So the inspiration of the lock-in, is really Ulysses on the mast in The Odyssey. Where he knew that he would be tempted by the siren's call or we know that we might be tempted by wanting to tinker with our investments or go all out when there is a problem in the market. And so he had his crew members tie him to the mast so that he'll be unable to jump overboard--which I think is very good metaphor for what happens in volatile times.

Now we have strategies that are really strictly tying us to the mast where you set your investment goals, you've set your investments, and you remove the power to change. Either because the vehicle itself is a long-term investment vehicle and you are not able to leave or you require that there is another signatory--you require that someone else is involved before you can take action, stopping you.

Then we have some situations where the bonds are a little bit looser--for example, a social friction. You tell your friends or investment colleagues that emerging markets is a terrible idea, and this is why I believe so. And then two weeks later when you see that your own performance isn't doing so well and emerging markets are really ramping up, you have that social friction. In your mind, you're thinking, "I just told these guys this, and they are going to think that I am inconsistent. They are going to think that I am a bad investor." And so that puts that little bit of friction that stops you from making a poor choice.

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Glaser: Returning to that planning mindset, why is that something that you might want to do?

Wendel: Sure. So it's important to remember that when we decide our investment goals, when we decide on a particular portfolio, we are usually in a very conscious, thoughtful, calculating mode. Psychologists call it your System 2 conscious thought. But when we are responding to signals in the market--whether it'd be someone on TV, whether it's something we are reading, whether we see a general fear that grips society--once there is a serious market downturn, we're in a very different mode of thought. We're emotional, being driven by our intuition. Psychologists call this your System 1. It's a very separate part of your brain that's working. And so one way to counteract that is to try and return to that conscious-planning mindset.

It's a common statement, but it's true. You take a break first and foremost; second you return to your original principles. So how did you work out this particular investment portfolio? You go back to that document. You force your mind to go through those steps, and that gets you back in the conscious, thoughtful mindset and avoids these gut reactions.

Glaser: How do you really know your limits? How do you know you are still falling off--to know that you are back in that mode?

Wendel: That's a great point because why would we want to go back in? Why would want to go through all this trouble when the market's going crazy and I have to act right now? Well, we have to know why that's so dangerous; we have to know out limits. Now, one of those limits and perhaps the most important is simply how our ability to resist temptation changes over the day, like a cycle.

They did a great study of judges, where they looked at parole rates over time. The parole rates went from 70% to 80% down to zero over the course of a few hours, where judges were giving most people parole to almost none. The only difference, same type of inmate, same question, the only difference was a few hours. The judges were getting hungry. They were getting tired of making these complex decisions and we face the same thing. We don't know how much simply being at the end of the day and being tired affects us and makes us harder to resist temptation.

Or for that matter having gone through a series of reports or going through a series of investment decisions makes that last one that last choice so much easier to make a stupid--so much easier for us to make us stupid choice. We get tired at such a basic level it's glucose in the brain that just gets worn out.

So knowing that helps. If you feel of the collapse inside, if you feel this mania and you have difficulty concentrating that's the sure sign that your self-regulation resources are being depleted or glucose in the brain getting tired take a rest. If you are not--if you have difficulty thinking about other topics that's another indication that your mind is tunneling as we call it, and you may be very good at thinking about that. But you are not thinking about all the other options. So if you find yourself extraordinarily focused that's another sign.

Glaser: So these are some maybe strategies that you can use to keep yourself from making mistakes.

Wendel: Yes, that's right.

Glaser: Is there any way to use these biases in your own favor may be to actually improve your results to make things better.

Wendel: Absolutely. So you think about it as when Jim Cramer is screaming on TV, or when you are seeing the stock tickers go by and you see the market is tanking. That's extraordinarily vivid. It's real; it's immediate in your mind. You can see yourself losing money. So one strategy is to fight vivid with vivid. Our minds think that the things that are most vivid are the most true, they are the most likely. So we see this crash--that's going to happen to me, I am going to lose all of my money, and so on. So what do you do? You say how can I make thoughtful, careful, long-term portfolio choices and investment strategy just as vivid?

You look at, for example, articles, other people talking about finding a niche, where people are talking about how good your existing investment strategy is. That's not to say, you want to just confirm where you started and say I'm great. But rather it's fighting vivid with vivid. You have to get away from thinking about all of this noise, all these things going on. Fight it with something else that's just as much in your face.

Glaser: That helps kind of psyche yourself out from--

Wendel: That's right.

Glaser: --what you don't want to do.

Wendel: So you are psyching yourself out. You are using our bias toward things that are vivid and you are using it in the favor of your long-term, thoughtful investment choices.

Glaser: Well, Steve, I certainly appreciate you sharing these strategies with us today.

Wendel: Sure. I am happy to be here. Thank you so much.

Glaser: For Morningstar, I'm Jeremy Glaser. Thanks for watching.