RATIONAL REFLECTIONS
By Bell Institutional
Are Your Instincts Hurting Your Returns?
Human behavior is shaped by instincts rooted in self-preservation, traits that ensured our ancestors’ survival. While these instincts remain ingrained in our DNA, they can undermine success in the stock market. Understanding how these natural tendencies conflict with effective investing is important for navigating the market’s complexities.
The Stock Market as a Complex Adaptive System
Michael Mauboussin, Head of Consilient Research at Counterpoint Global, describes the stock market as a complex adaptive system (CAS), characterized by dynamic, non-linear, and emergent properties driven by the interactions of diverse agents. In his 2002 paper, "Revisiting Market Efficiency: The Stock Market as a Complex Adaptive System," he identifies three key features:
1. Heterogeneous Agents: The market consists of numerous participants (e.g., retail investors, institutional investors and institutional traders) with different decision-making rules and resources (including algorithms), goals, and levels of information. These agents adapt their strategies based on market conditions and past experiences, leading to evolving behaviors.
2. Interactions: Agents engage through trades, information sharing, and reactions to events, creating feedback loops. Positive loops amplify trends (e.g., herding during bubbles), while negative loops stabilize markets (e.g., profit-taking after rallies), shaping market dynamics.
3. Emergence: Collective interactions produce outcomes, such as price movements or volatility, that cannot be predicted by analyzing individual agents alone. The market exhibits properties greater than the sum of its parts, from relative efficiency to extreme volatility during crashes.
Naturally Occurring Behaviors
1. Following the Herd
• Survivalist Advantage: Herding enhanced safety, as group cohesion protected against predators and threats. Removing oneself from the group decreased the odds of survival.
• Impact in a CAS: In the stock market, herding drives investors to chase popular stocks or trends, especially during bubbles or panics. Herding creates positive feedback loops, inflating prices beyond fundamentals (e.g., the dot-com bubble or GameStop’s 2021 surge). Investors who follow the crowd often buy high and sell low, locking in losses as prices revert to intrinsic values.
2. Assimilating to the Group
• Survivalist Advantage: Assimilation secured social acceptance, ensuring access to shared resources and group protection. Mimicking group norms minimized the risk of ostracism.
• Impact in a CAS: In markets, assimilation leads investors to adopt prevailing narratives without scrutiny, such as “tech stocks always rise” or “bonds are safe.” The market’s heterogeneity, not homogeneity, drives efficiency, and blindly following groupthink limits the ability to exploit mispricings. This fueled inefficiencies before the 2008 crash, when analysts underestimated risks.
3. Being Lazy
• Survivalist Advantage: Conserving energy was vital when resources were scarce. Laziness prioritized efficiency, avoiding unnecessary exertion.
• Impact in a CAS: In investing, laziness manifests as failing to research or relying on “expert” tips. A CAS’s complexity demands active learning to adapt to shifts, such as new regulations or technological disruptions. Lazy investors miss mispriced assets or fail to adjust portfolios, leading to underperformance. Many investors missed Meta in November 2022 when it was down 77% from its peak. The business was never broken, but investors needed to do the homework to have the confidence to go against the grain.
4. Running Away from Danger
• Survivalist Advantage: Fleeing danger ensured survival by avoiding predators or threats. Loss aversion prioritized avoiding harm over seeking gains.
• Impact in a CAS: In markets, this translates to panic-selling during downturns or avoiding “risky” investments. However, to achieve desirable returns, investors must accept a certain degree of risk. There is no such thing as a free lunch. A famous quote from legendary investor Warren Buffet reads, “Buy when there is blood in the streets, even if the blood is your own.”
Why These Traits Fail in a CAS
Mauboussin’s CAS framework highlights why survivalist traits misalign with the market’s probabilistic nature:
• Short-Term Bias: Herding, assimilation, laziness, and flight prioritize immediate comfort, while investing demands long-term discipline and contrarian thinking.
• Feedback Loops: These traits amplify destructive feedback loops, such as panic-selling or speculative buying, as investors react emotionally to signals.
• Missed Heterogeneity: Independent analysis leverages the market’s diversity to find mispriced assets, but survivalist instincts foster conformity, reducing returns.
Practical Takeaways for Investors
To counter survivalist instincts in a CAS:
• Resist Herding: Use valuation techniques, such as discounted cash flows, to assess investments, ignoring market hype. “Expert” or consensus opinions are often incorrect. As an analogy, popular opinion is like the point spread in a football game. It’s nice to know that your team is a seven-point favorite or a three-point underdog. It tells you something about expectations, but it doesn’t mean that that is what is going to happen.
• Think Independently: Challenge consensus by researching primary data, like company filings or economic indicators. Even experts, like Goldman Sachs, shift predictions rapidly.
• Stay Diligent: Regularly review portfolios and market conditions to adapt to changes, avoiding complacency.
• Embrace Volatility: View downturns as opportunities to buy undervalued assets, capitalizing on the market’s long-term upward trend.
• Maintain Diversification: A diversified portfolio mitigates the market’s ups and downs and reduces the impact of the behaviors discussed previously. Accepting market returns can be wiser than chasing outsized gains.
By overcoming these instincts, investors can better navigate the stock market’s complexity and improve their long-term outcomes.
Keeping the Feedback Loop Open
It is entirely possible that you disagree with a variety of the assumptions in this article. Rather than dismiss alternative analyses as wrong, we are better served by keeping our feedback loop open. If you would like to share your opinion and/or critique ours, please feel free to share your thoughts. One of the great aspects of investing is that if you get something wrong, you always have the opportunity to change it. Refusing to change a narrative, just because it is yours, is nothing more than hubris.
End Notes
Jordan Bancroft, CFA, CAIA® VP/Portfolio Manager
Fargo
jbancroft@bell.bank
¹Meta peaked on September 7, 2021, at $382.18 and bottomed on November 3, 2022, at $88.91, when using daily pricing.
Disclosures
This communication reflects the personal opinions, viewpoints and analyses of the Bell Institutional Investment Management (BIIM) employees providing such comments, and should not be regarded as a description of advisory services provided by BIIM or performance returns of any BIIM client.
The views reflected are subject to change at any time without notice. Nothing in this communication constitutes investment advice, performance data or any recommendation that any particular security, portfolio of securities, transaction or investment strategy is suitable for any specific person.
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