Fear and (Dys)functionality

Who of us have not pondered acts of bravery and thought, “Would I have been able to do that?” Especially when the act is deliberate and not instinctive. But bravery itself is not an absolute quantity – it has to be calibrated in relation to how much we fear the consequence. Varying levels of fear mean that different people need different doses of bravery to perform identical acts. Great acts of valour or daring may not really require courage in the absence of fear. Equally, we may be dismissive of people’s very real fear of things we may consider trivial – or even funny…

This got me thinking about risk anomalies. The whole field of behavioural finance describes our systematic behaviours that defy objective evidence – is this true of our anxieties? Fear keeps us alive by helping us stay away from the edges of tall buildings, stepping in front of buses, provoking the bouncer and posing next to the nice wild elephant (most of us anyway). We have a visceral fear of drowning, heights, sharp metal things, men with beards and horns on their helmets, poisonous things that slither or crawl, teeth and claws, and of being burned alive. This primal, instinctive fear is coded in our DNA, and it serves an important evolutionary function. We live to fight another day and pass on our genes. Yay!

However, it is less clear that our primal reflexes produce rational results when it comes to processing data and our modern “threat environment”, which looks very different (for now) to the one our Palaeolithic ancestors faced. In fact, it is our instinctual responses that make people fear flying high above the ground, which is very safe, but blasé about driving cars on the ground, which is much less so. Young men make courageous try-saving tackles but run screaming from their mothers, tiny needle in hand, for their flu jab – just like their fathers. People who are too scared to swim because of sharks stay on the beach, cigarette in hand sans sunscreen.

It appears that we have some serious cognitive biases around risk, and biases are seldom a good thing. In fact, irrational fear can become self-fulfilling. You are far more likely to fall off your mountain biking by tackling obstacles overly-tentatively and without momentum. You will make a safer emergency landing if you are not frozen at the controls gripped with fear. You will climb more confidently when you know the breaking strain of your rope. You will tackle the impossible after you see another mortal succeed who provides encouragement. You are most likely to take risk when you know that doing so is essential. In “Death of an Old Man”, Roald Dahl writes about a Spitfire pilot who flies fearlessly in the Battle of Britain when the risk of not doing so was existential. He then describes the growth of chronic fear as the war draws to an inevitable close, where his sacrifice would make no difference to the outcome.

But our primal instincts can undermine our rationality in making investment decisions and sticking to strategy. From my examples above, we can draw some conclusions about managing fear. It’s easier to take risk when we know it is essential to avoiding a bigger risk, like having a shortfall at retirement and ending up indigent. We can avoid the instinct for “flight” when investment values are plummeting if we have a better knowledge and understanding of the nature of markets and the hazards of market-timing. Coaching and encouragement from someone with better understanding helps navigate the fear of the unknown. Experiencing the ups and downs of markets makes us more seasoned risk-takers, far less fearful than the first time around!

There is a lot that is still pretty cool about carrying around that caveman DNA and occasionally expressing our more primitive instincts in a non-destructive way – it’s fun being human! But understanding the difference between real and apparent risk makes us better decision makers. Risks in the modern world are often of a long-term and strategic nature that we don’t have a great “feel” for – they are best managed with our brains and the brain is a learning organ that can be taught and coached. In all of this, the value of the role of the adviser as coach and guide is abundantly clear, as is that of the investment manager, in whose skill the adviser needs to trust in order to engage their clients with confidence.

 

Source: Portfolio Metrix – Brandon Zietsman