In a new fortnightly column for the Business Times, Kajanga Kulatunga, an investment specialist based in Sydney, Australia looks at the intricacies in the world of investing. The column will discuss the importance of understanding various investment themes from the standpoint of readers as providers of capital, or simply, investors.

The investment profession has rightly been condemned and found wanting during the last two years, since the onset of what is now dubbed the global financial crisis. Whilst many expected Sri Lanka to be immune from any direct impact, the crises brought home the age old proof that gullibility does not discriminate. Investors in “Golden Key” and individuals with momentous names (Sakvithi, Danduwam Mudalali, etc) were reminded the hard way of the prudence of due diligence. While it may seem extremely ironical to attempt to write a column on personal investing against this backdrop, it also provides the best opportunity to educate investors when everyone’s paying attention.

The purpose of this column is to explore ideas around investing and specially the importance of human behaviour in the investment decision-making process. Surprisingly, the best answers as to why people make mistakes around money come from non-financial fields.

The fields of psychology, decision sciences and neuroscience have been converging on research to understand how humans make financial decisions. Money is an emotive issue to people. Our views about money and investing are part genetic and part driven by life experiences. These views once formed, remain deeply rooted. A big misconception about investing rests on the false premise that people are risk averse. Humans are loss averse, not risk averse. Risks excite people, while losses induce fear.

Money is not the goal of investing. It is the currency that buys emotional goals. All investing decisions are attempts to meet emotional goals. Psychologists and neuroscientists have been converging on the thesis that the human brain and thinking has two sides to it. One is reflexive (intuitive and automatic) while the other is the reflective (rational). The reflexive part is more commonly used and acts as a pattern recognition machine to help us get through daily activities.

This is so because of the amount of energy the brain requires to function. At rest the brain accounting for less than 2% of total body weight consumes 20% of total oxygen intake. Therefore it is much easier for the brain to filter out what’s not important, than to individually analyse what is.

The energy that is conserved gets used when the reflective part kicks in as a result of the intuitive systems inability to handle a situation or when deep analysis of a complex problem is encountered. Unfortunately, investors tend to use their reflexive “pattern recognition” brain, instead of the more analytical reflective part, to make most investment decisions. It is amazing how little it takes to get the predictive circuitry in the human brain into gear.

Research has shown that the brain begins to anticipate another repetition after a stimulus occurs only twice in a row. The reasons for this are due to evolution. Whilst technology has improved and the rate of change has increased dramatically over the last two hundred years, our brains have evolved at a slower pace. In fact, our brains are still stuck in the wild plains of Africa trying to evade predatory animals and secure food!

The first lesson in investing is therefore to be objective and unemotional as far as possible when evaluating or making an investment decisions. Second, understand that there is a difference between risk and uncertainty. Risk has an unknown outcome, but we know what the underlying outcome distribution looks like. Uncertainty on the other hand also implies an unknown outcome, but we do not know what the underlying distribution looks like. While uncertainty is what emotionally bothers most investors, the investment industry has built erroneous models assuming limited risk outcomes. This disconnect became glaringly obvious during the Lehman meltdown.

The best way to defend against such unknowns is to ask three questions before making any investment decision. First, do you need to take the amount of risk that this investment calls for in order to achieve your goals? Most people have little idea of how much money they really need. Second, how do you know the risk you are about to take will be rewarded? Check the history of similar investments and individuals involved.

Last, can you afford to lose all the money you risk with investing and not have a material impact on your life? Invest only that portion of your hard earned wealth, which you can afford to lose completely.
If only investors in the recently collapsed “Ponzi” schemes had asked the above three questions, many would have been spared the anxiety and heartbreak they have had to endure.

For feedback and questions, you can reach the author directly on kajangak@gmail.com.