Does nature trump nurture when it comes to investing?
Biology is not destiny, but research indicates our genes play a large part in our investment approach.
New York Stock Exchange traders: We are, according to one finance professor, biologically predisposed to screw up in our investment choices. Photograph: Brendan McDermid/Reuters
Investing is simple but not easy, as Warren Buffett once quipped, which is why so few people seem to follow that simple dictum about buying low and selling high. Can we do anything about it? Can ordinary people learn to be good investors? Or are we condemned by our genes?
Genetics has a lot to do with investment performance, according to Swedish finance professor Henrik Cronqvist, accounting for up to 45 per cent of investor behaviour. Other factors, such as age, education, gender and wealth, are deemed nowhere nearly as important, while the impact of parental guidance weakens significantly as people age.
Cronqvist, who has co-authored a number of studies into the area, used the Swedish Twin Registry – the world’s largest – to analyse the investing behaviour of almost 38,000 twins in Sweden. Investing similarities were much more obvious among identical twins, he found, than non-identical twins – the latter share about 50 per cent of their DNA, compared to 100 per cent in the case of identical twins. In fact, the correlation in investing behaviour among twins that were raised separately – there were 716 cases – was almost identical to that of twins that were raised together.
The research, he concludes, indicates many well-known investing errors, such as poor diversification, overtrading, loss aversion, chasing after yesterday’s winners, and “lottery-type” investing behaviour, are “manifestations of innate and evolutionary ancient features of human behaviour”. We are, in essence, biologically predisposed to screw up.
Environmental influencesOf course, genetics isn’t everything. “Even genetically identical investors who grew up in the same family environment differ substantially in terms of their investment behaviours,” Cronqvist notes. A person’s environment and individual life experiences, he adds, must therefore play an important part in shaping investor behaviour.
A recent Cronqvist paper, Value versus Growth Investing: Why Do Different Investors Have Different Styles?, found investors with adverse economic circumstances – for example, those who grew up during the 1930s Depression, or who entered the job market during an economic downturn, or who came from a poorer background – were more likely to be drawn to a value investing approach several decades later in their lives. (This finding has obvious implications for Irish investors who, scarred by the property crash and banking meltdown, are likely to take a much more conservative approach in the decades to come.)
Turtle tradersThose who suggest that nurture trumps nature will point to the so-called turtle traders, the subject of a fascinating experiment in the early 1980s. Richard Dennis, then a high-profile commodities trader, believed anyone could become a great trader; his partner, William Eckhardt, believed otherwise, thinking the best traders were born, not made.
To settle the argument, they placed an ad in the Wall Street Journal, inviting inexperienced individuals to a training programme. Eventually, 23 were chosen and taught the trend-following approach adopted by Dennis and Eckhardt. After a one-month trial period, some were given real money to trade, the accounts ranging in size from $250,000 (€185,000) to $2 million. The common perception is that Dennis won the bet. Over the next five years, the turtles – the name came in the aftermath of a visit to a turtle-breeding farm, Dennis claiming he would “raise traders like they raise turtles in Singapore” – reportedly made $175 million. Some went on to become successful fund managers.
However, it would be premature to deduce, as some do, that anyone can be taught to be a great trader or investor.
Firstly, those chosen were a bright bunch - “among the brightest I had ever met”, says Curtis Faith, one of the original turtles who later penned a book on the subject, Way of the Turtle.
Secondly, Faith notes his early returns were much better than those of his fellow traders. Why? He stuck to the rules, whereas others overrode them.
“By some freak of biology or upbringing, it was not difficult for me to be consistent in my trading,” Faith recounts. “We all had been taught exactly the same thing, but my return was three times that of the others. The difference in return had nothing to do with knowledge and everything to do with emotional and psychological factors.”
Faith adjudges Dennis and Eckhardt’s nature/nurture bet to be a draw. Yes, investment approaches can be taught, he concludes, but some are better equipped with the psychological demands than others.
Brain wiringAcademic research confirms that how our brains are wired can affect investment performance. In fact, a little bit of brain damage may be no harm. One Stanford study was inspired by research that examined the superior driving decisions of people with limited brain damage.
Healthy drivers, it was found, hit the brakes in panic when confronted by an icy patch of road, causing their cars to spin out of control. In contrast, people who had suffered brain damage that impaired their ability to feel fear, stayed cool. They remembered the fact that hitting the brakes is a no-no in such circumstances, and gently crossed the icy patch.
Clearly, people “deprived of normal emotional reactions” sometimes make better decisions, the Stanford researchers concluded, which inspired them to conduct an investment game. In the game, healthy participants became risk-averse after experiencing losses. In contrast, a second group – people who had suffered damage to the amygdala and insula regions of their brain – took no notice of prior losses, and consequently made better investment decisions. Successful investors may be “functional psychopaths” who do not experience as much fear as ordinary people, the researchers suggested.
Whatever about having psychopathic tendencies, the best traders certainly appear less emotional than the rest of us. One study measured the heart rate and blood pressure of real-time traders, and found the most experienced ones had a lesser physiological response to information surprises, remaining relatively unfazed in periods of market volatility.
Education implicationsAchieving a Zen-like state of calm is beyond most people, unfortunately. “To the extent that behaviour among investors is genetic, we would expect that investment behaviour can persist despite ample feedback and education,” Cronqvist cautions. “This has implications for the challenges of educating the public.”
That same point was recently made by US firm Dalbar, which has found the average investor earned just 5.02 per cent annually over the last 20 years, compared to 9.22 per cent for the S&P 500.
Investors seem to instinctively adopt a ‘buy high, sell low’ approach, a point Dalbar has been making, in vain, for the past two decades. “Attempts to correct irrational investor behaviour through education have proved to be futile,” said Dalbar, which said this approach has now been “totally discredited”.
The best approach, perhaps, is to recognise our biological limitations and take steps to minimise their potential for harm. Investors may be told it’s a bad idea to rotate out of stocks and into bonds or cash at times of market panic, but they’ll likely do so anyway. Accordingly, behavioural finance guru Richard Thaler recommends the creation of a default investment fund that automatically rebalances an investor’s portfolio, both cyclically as the market rises and declines, and as people age, reducing stock holdings as retirement nears.
Automated solutions are not perfect, of course but the alternative – emotional investing driven by hardwired biological impulses – is likely to deliver much worse results.