A global pandemic. Massive job losses. Consumer product shortages. Police brutality. Unsettling images of violent riots juxtaposed against peaceful civil disobedience. 2020 has been one thing after and another, and to say it has created a lot of stress for many people would be an understatement.
However, despite these stressors, life goes on. Decisions — big and small, significant or trivial — must still be made. Unfortunately, we are not the greatest at making complex decisions at the best of times. And stress only makes it worse.
Psychological research has pointed to a few potential causes. Some research has shown that heightened stress levels cause our attention to narrow. Humans already have a tendency to focus on often irrelevant, but readily accessible, characteristics when making decisions. Factors like the familiarity bias and recency effect lead institutional investors to overweight equities of local businesses or retail investors to buy stocks recently in the headlines — habits that result in lower returns.
When all the headlines are bad, and we feel overwhelmed, we adopt a simpler mode of information processing, relying even more heavily on such superficial information for making decisions. Panic selling at the bottom just because everything is in the red may ease our acute stress, but it’s unlikely to be a great investment decision.
Other research has shown that the more stress people feel, the more inclined they are to see patterns that don’t exist. Researchers at the University of Texas formed two groups of undergrads — one group was given a task that was simple, and the other an impossible and frustrating task. When presented with the real experiment, which was intended to measure their ability to recognize patterns, the stressed-out students reported seeing more images that didn’t exist in digital pictures and consistently selected certain stocks based on what was actually random, uncorrelated data.
Time and again, the group that felt more stress claimed to see images where there were none and found stock patterns that didn't truly exist. It’s not terribly difficult to see how this could impede real-world investment decisions.
However, struggling to remain rational in the face of stress isn’t merely a test of will. There are actual physiological mechanisms at work when we are acutely stressed out that impair our ability to make rational, clear-headed decisions.
Acute stressors trigger our glands to release elevated levels of the hormone cortisol into our circulatory system as part of the so-called “fight or flight” response. Part of this process also reduces activity in our pre-frontal cortex, where thinking occurs, while adrenaline simultaneously elevates basic physiological activity, like increasing our heart rate and breathing. Our body is being primed for one binary but critical decision: attack the threat or flee from it. These mechanisms help with that simplistic job.
But research shows that individuals with elevated levels of cortisol make riskier — and worse — decisions when confronted with more complex problems. One study administered oral steroids to the test subjects, while the control group received a placebo. Subjects were then asked to select between several different gambles. Those individuals who had ingested the hydrocortisone tablet consistently made the riskiest, and worst, bets.
Cortisol can fire us up as we rapidly decide to defend ourselves or flee from a physical threat, but it’s highly counterproductive when it comes to rapidly weighing complex odds.
Even something as apparently innocuous as being a little tired or hungry can affect our judgement. Another interesting study investigated factors affecting the decisions of parole judges. While the authors hoped that variables such as the facts of the case, severity of the crime, and prior precedents would drive impartial judicial decision making, they were dismayed to find that the single most highly correlated factor with decision was time of day. In the morning, early afternoon, and after a late day break, parolees received a favorable ruling about 65 percent of the time. However, in the hour or so before lunch and before the afternoon break, the percentage of prisoners granted parole fell precipitously to zero.
Tired and hungry judges simply didn’t have the mental stamina needed to rationally deliberate, and so they made the most energy efficient decision possible: no to everything. Again, it’s not terribly hard to conceive what the investment parallels might be.
We crave certainty and use mental shortcuts when making decisions. Stress increases our reliance on these heuristics and makes us more prone to project patterns that aren’t there, which in turn makes us even more overconfident than we normally are. And biological responses to these stressors prod us to make more extreme decisions precisely when we should be most circumspect.
In his book The Behavioral Investor, behavioral finance guru Daniel Crosby gives readers a great acronym for how investors should handle moments of acute stress. When making any investment decision, an investor should first try to assess their emotional state. And if they are feeling:
They should HALT! And not make any investment decisions in the spur of the moment. Walk away, get some space, some rest, some time and perspective before returning to the decision with a clear head once the emotional state has passed. Emotions are chemical reactions; simply letting them pass can fix a good deal of the ills.
However, this first requires a bit of EQ, or emotional intelligence. Too often I’ve seen investment professionals attempting to “control” their emotions by simply bottling them up, pretending they don’t have them. This never works. Instead of controlling them, simply denying the anger or frustration and covering it up means you will likely make a decision affected by those emotions without being aware of the consequences.
Own the emotion, acknowledge it, and allow yourself to experience it. We are emotional beings; there is no shame in that! Just don’t make any decisions during the heat of the moment.
Another way to manage the impact of emotions on our decision making is to systematize processes via predefined rebalancing or trading rules. For instance, many institutional investors will often automatically rebalance back to a target allocation if an asset class falls or rises by a certain amount, say 5 percent. If the stock market falls by 5 percent, they will add to hit their target allocation and if it rises by 5 percent, they will sell to get back down.
No emotion possible there; algorithms don’t have feelings. While they may not be perfect, helping us remain disciplined during times of stress is precisely the strength of such systematic tools.
However, stress is not always acute. Our body’s response to acute stressors — that fight or flight response I mentioned before — is typically immediate. Along with cortisol, production of adrenaline is also stimulated, which provides the boost of energy required to deal with the immediate threat.
But chronic stress is different. Chronic stress occurs when there isn’t any urgent danger facing us. Whether it’s the persistent daily pressure of long days, heavy workloads, or demanding bosses, there may not be a direct target for our adrenal response, but there is certainly stress.
This persistent overhang of stress results in chronic exposure to elevated levels of cortisol — and permanently higher levels of cortisol in our bloodstream is a very bad thing. Similar to acute cortisol exposure, it reduces the quality of our judgement and our ability to assess objective probabilities. However, research on its impact on financial decision making shows that while it dramatically alters our risk preferences, it does so in the opposite direction of acute exposure.
Instead of stimulating aggressive risk taking, chronic stress results in sub-optimally low levels of overall risk taking. It is an important effect to consider when assessing required staffing and processes of large capital allocators.
Even more problematic: Chronic stress is also correlated with a host of serious mental and physical medical issues as well, such as anxiety, depression, obesity, hypertension and heart disease. It should be pretty obvious how this reduces the quality of life of employees, while simultaneously lowering their job performance and increasing overall costs.
Perhaps these insights cast new light on our industry’s tendency towards marathon workdays, the pressure of constant deadlines, and the never-ending quest to win that next deal. That six-hour due diligence meeting might not be so much a testament to your endurance as it is your folly.
Rather, we should try to implement disciplined, rules-based processes for as much of the day-to-day investment decision making as we can. The more often something gets done, the more we should automate it as much as possible. We should limit truly discretionary judgement to only the most strategic and impactful long-term decisions, and we should allocate dedicated white space on our calendar to them.
This could mean empowering asset class directors at asset owners to make manager hiring and firing decisions — subject to investment policy statement guidelines, of course — similar to how portfolio managers make buy and sell decisions on individual securities at asset managers without having to go to a formal committee every. Single. Time.
This also means eliminating a lot of the busywork related to these steps. Whether that’s the face time of pointless meetings, pages of copy and paste memos that add little original content, and all the deadlines and planning associated with them, sometimes less is more. Eliminating non-value-added formalities could free up perhaps as much as 25 percent to 50 percent of investment work hours.
And more effective stress management for investment professionals would not only make employees happier and healthier, it would help investment firms make better decisions on behalf of their clients and beneficiaries. And maybe that also would give stressed out end investors a little peace of mind.