Mind The Gap: Trust Your Gut? Use Your Brain!

 


Mind The Gap: Trust Your Gut? Use Your Brain!

I recently watched a webinar by Morningstar titled "Mind The Gap." This presentation focused on the gap between mutual fund returns and investor returns. One would think that these two metrics would be the same - over both short and long time horizons. The sad truth is that even with all the self help available to retail investors, there is still the common urge to chase good returns by buying previous winners (after their big runup) and to sell recent losers (just before their rebound). This phenomenon is the main focus for a relatively new field of research named behavioural economics.

Trust Your Gut?

This is a great mantra for a romantic relationship or dark alley scenario. It is, however, a suboptimal (translation: lousy) strategy for any decision that involves a dollar sign and a date on a periodic statement. The reason is literally hard-wired into our anatomy. When we think of our autonomic nervous system, there are three basic portions - the sympathetic, the parasympathetic, and the enternic nervous systems. The enternic nerves help regulate the functions in the gastrointestinal tract. The parasympathetic nerves main function is to regulate our routine bodily functions such as eating, sleeping, and breathing.

The sympathetic nerves control our "fight or flight" reactions to (assumed) life-threatening situations. This portion of our nervous system is critical to survival of encounters which have been - or could be - dangerous to our physical body. All three of these autonomic nerve groups have their specific functions and values to us as a species hoping to pass our genes along to our next generation. Unfortunately, they often override rational thought during events in which we are not in imminent danger.

Source: Merck Manuals

Use Your Brain!

The alternative to letting our sympathetic nerves kick into gear is to consciously take a step back and use our brain to asses the true risk of the financial situation. This conscious effort takes courage, education, and experience. It is only possible after taking a "deep breath" and walking around the problem to determine the optimal decision to be made with the information in hand. Many times, the optimal decision is to do absolutely nothing and simply hunker down and wait for the tide to change. Other times the optimal solution may be the least terrible among many competing alternatives. Designing a data-flow and decision-making process to predict and address risky situations is the key NOT jumping ship just when the bilge pumps are about to autostart. This is what is referred to when economic theorists refer to as rational investors.

"We merely try to be fearful when others are greedy and be greedy when others are fearful." - Warren Buffett

Location: JQR Capital

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