Why Evolution Makes Us Bad at Investing (and what you can do about it)

In my work as an experienced investment and financial advisor, I am often hired to act as both an expert and a coach to my many clients.  Part of my job involves teaching and guiding clients to optimize complex decisions and sometimes even to fight against their own instincts, especially when markets are volatile and scary.

Theoretically, investing should be easy and involve a series of logical tradeoffs and choices determined by cold and calculated analysis.  However, the reality is that in many cases, emotions are as much in the mix as reason when it comes to trying to achieve investment success.

Even when you have a good plan and the right advice, sticking to that long-term investing and financial plan can sometimes be challenging for many people in the face of market volatility. This is why many who are on the right track cash out and fail to get reinvested when they get scared by the market.

Since I started Ridgewood Investments in 2002, and even in my prior life as a private investor managing my own portfolio and that of my parents, I was always aware that the ability to control and manage emotions is critical to success in investing.  This is why many outstanding investors, including Warren Buffett often talk about the importance of temperament (rather than just intellect) to the achievement of outstanding investment results.

This is true not only for individuals, but also for markets as a whole.  Markets themselves are sometimes driven by so-called animal instincts as chronicled in Scottish journalist Charles Mackay’s 1841 classic Extraordinary Popular Delusions and the Madness of Crowds.  Indeed, as I write this in 2020, there is possibly a mania underway again in certain very highly valued companies traded in the stock market.

It’s not just an accident that so many individuals have difficulty making solid investment choices and sticking to them for long enough to get the benefit.  In fact, the culprit that explains why so many of us are so bad at making certain types of choices in the modern world (including investment choices) is how and under what circumstances we evolved.

The Direct Link Between Evolution and Bad Investing

The first Homo sapiens emerged approximately 200,000 years ago on the savannahs of Africa where individuals lived in small hunter-gather tribes that scraped out an existence in a very different world than our modern world of today.

The father of evolutionary theory, Charles Darwin observed that evolution works over eons because traits in a species are heritable and varied, with new traits popping up from what we now know to be genetic mutations. Evolution selects those traits that are advantageous to survive through the mechanism of natural selection.

Natural Selection can itself be further categorized into:

  1. Environmental selection which allows traits that promote survival like strong bones to be passed to the next generation
  2. Sexual selection through which traits that make a certain individual more attractive to the opposite sex and make mating more likely.

Evolution, however, works quite slowly.  The adaptations of our current bodies and minds were developed for survival in a very different environment than the one we live in today.  Many of the inventions that have made life so much more plentiful including things like money and stock markets and much of our technology are very recent (hundreds or at most thousands of years old), whereas our minds are mostly evolved for the world the way it looked fifty or even one hundred thousand years ago.

Since our lives today look very different than those of our ancestors but our minds have not had enough time to evolve to fit the modern world, many of our decisions today are still driven by mental short cuts and inherited traits that helped our ancestors survive but make us prone to making terrible choices.

Unfortunately, many of these traits operate at an automatic, emotional and subconscious level and thereby can be extremely difficult to recognize and neutralize even when they may be extremely counterproductive or even completely irrational.

Evolutionary Psychology Provides Insight into the Emotional Programming that Prevents us from Making Great Investment Decisions

Evolutionary psychology is a relatively new field of study focused on how evolution shaped human behavior.  It is a multidisciplinary field drawing from cognitive psychology, evolutionary biology, genetics, anthropology, and archeology. In the same way that physical traits were evolved through natural selection, patterns of behavior that increased chances of survival or mating were also passed down from one generation to the next and are cataloged in great detail by the Evolutionary Psychologists.

For context, Until the mid-twentieth century, economists maintained that humans were rational actors. However, there were too many counter examples of irrational decision-making that the economists had a hard time explaining.  A few decades ago, the field of behavioral finance emerged within economics to catalog and explain how in certain predictable circumstances people were consistently prone to making irrational choices. While behavioral finance explained the circumstances in which we tend to make poor choices, it could not actually explain why.

Evolutionary psychology goes further by explaining that the problems identified in behavioral finance are caused by traits that evolved for very good reasons and helped us survive and pass on genes that reinforced those adaptations.

Traits that reinforced survival and mating advantages in a world of danger and a never-ending search for basic sustenance no longer serve us well in an environment of plenty and dynamic complexity.  Some of these traits include our tendency to make split second emotional decisions and run away from perceived danger.  A good example of our flashing danger reflex is that our brains constantly and subconsciously look for patterns as a short-cut to identify future peril.  On the plains of Africa, yellow and black stripes in our peripheral vision automatically triggered an involuntary spike in fear and heart rate followed by an urge to flee.

However, investing is a great example of how this same evolutionary programming can work against us in the modern world.  Markets and investing are a relatively new idea in the human species, only emerging in the last ten thousand years or so as primitive markets developed in our settlements and slowly became more sophisticated.  That same part of our brains that is great at automatically detecting tiger stripes in the distance also kicks into high gear when it encounters other patterns in the modern world that have very different effects but can still trigger the danger and panic based emotional response.

Some of Our Evolved Behavioral Traits That Lead to Bad Financial Decisions

There are many behavioral traits from our evolutionary programming that can cause us to make poor choices (including investment choices).  A few of the most relevant to investing are:

  1. Emotional Decision Making – Humans are emotional creatures. We have evolved to feel strong emotions in reaction to our environment and thereby make instinctual decisions where slower, more considered and nuanced decisions would be more appropriate.
  2. Loss Aversion – The prehistoric world was one of scarcity. Our ancestors could not afford to lose what limited resources they had.  As a result, we evolved to feel intense pain and discomfort when faced with losing something we have.
  3. Overconfidence – Confidence was key for high standing in the tribe. We have evolved to feel confident about things we know next to nothing about because that same air of confidence made us more attractive to mates.
  4. Classification – Our minds are good at classifying things. We use limited information to form sweeping generalizations that allowed us to find food, avoid predators, and identify our tribe members from other potentially hostile humans.  Our brains also consume the maximum amount of energy in our bodies and so classification also helps us to conserve energy and effort for survival instead of processing every occurrence individually and from scratch.
  5. Reliance on Gossip – Humans are social creatures. The ability to rapidly exchange information, even if it was potentially unreliable, with members of our tribe in unpredictable environments allowed us to survive.

Compare these traits with those needed to be a rational investor. The same tendencies that were essential to our survival undermine us in making rational long-term decisions. Markets fluctuate all the time and when they do, we’re hit with constant feedback from our investments. This feedback hits its apex during a market crash or market panic when value is being “lost”.

Unfortunately, just as this is happening, our instincts kick in and we can experience very intense emotions that surface in response to the perceived threat or loss. The drive to run away from the danger and not lose what we have explains why otherwise intelligent, thoughtful investors will pull their money out in a bear market (typically the exact opposite of what reason suggests you should be doing).

Even when we know rationally that the loss is likely temporary, the pain of loss can be so intense that most people find it difficult to not give in to their emotional impulses.  Even if you are one of the few that does not panic and sell, you might still be unable to actually put new money to work and thereby really benefit from the opportunities created by the bear market declines.

Optimal financial decisions should ideally be based on long-term calculations and careful research. In most cases, however, our emotions serve as a hindrance to enjoying investment success by bypassing our ability to weigh complex decisions carefully.  Let’s look at how a few of the above evolved psychological traits can commonly lead to bad investment decisions.

Our tendency to automatically classify things means that we tend to oversimplify. Classification which was useful in determining things like what berries were safe to forage can be too simplistic when applied to the complexity of the modern financial system. 

As Einstein observed, “Everything should be made as simple as possible, but not any simpler.”  Unfortunately, our tendency to automatically classify makes us likely to assume we know what we are observing and thereby make poor financial decisions.

Similarly, our instinct to gossip leads us to give undue consideration to the casual ideas we pick up from friends, family, celebrities, and self-styled money gurus. Your father-in-law might be an excellent doctor, but if you are investing in a certain stock or keeping your life savings in cash because of his opinions, you may be doing yourself a disservice.

Instead of relying on our evolved mental short cuts, financial decisions need to be highly personalized and based on a careful weighing of the pros and cons of the choices we have to select from.  Prior experience making similar complex choices and access to the analytical tools and mental models needed to sift through all the options is extremely helpful to making the right decisions.  Ones that would increase your wealth while sidestepping unnecessary pitfalls.

How We Can Counter Evolutionary Instincts to Make Better Decisions

Now that you know why we tend to make seemingly irrational financial decisions – how can you avoid that fate?

Our innate programming is hard to suppress, however, there is hope.  Awareness that evolution has programmed us to make poor decisions is the first step in being able to minimize the possibility of being victimized by this programming.

Some steps you can use to counteract our evolutionary programming when it comes to investing and other complex decisions include:

  1. Make it a habit to pause and try to recognize and remove emotion from the equation when making financial decisions. Look at your situation from a third-party perspective. What would you advise a friend to do in the same circumstances?
  2. Reframe short-term losses by forcing yourself to also think longer term. Ask yourself prior to making any moves to also focus on what will be the best choice for your finances 5 to 10 years down the line? Suppress the urge to give into fear and act on your short-term loss aversion instinct.
  3. Avoid overconfidence and simplistic classifications. Ask yourself if your model of the current situation is appropriate under the circumstances.  Do the research and weight both sides carefully before making any changes or choices.  Take your time.
  4. Avoid gossip.  Recognize that great investments are rarely made as the result of hearsay or casual dinner conversations.  At an absolute minimum, any “hot tips” should be researched thoroughly or ignored, and never followed blindly

Few people are aware that our evolutionary instincts can undermine our results in the modern world.  Fewer still have the experience and maturity to replace these evolved instincts with intellect and reason in the quest to make better investing decisions.

Even many financial advisors fall into the same traps (they are human too). Finding advisors you can trust and who have honed their ability to avoid basing complex modern decisions on prehistoric emotions and behavioral patterns is one of the most important criteria you should consider before selecting your advisor.

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