Are successful investors born or made?
5 min read 30 May 2014, 07:56 AM ISTIt certainly helps if some of the traits of decoding the market are already encoded in an investor's DNA
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To us lay investors, the Soros’s and Buffett’s of this world seem to have been born with a knack for investing. They have taken the tide at the flood on their way to a fortune while a multitude of us are bound in the miseries of day trading. Navigating treacherous markets is a skill and they make it look easy.
In theory, all that is required to be a successful investor is to know when to buy, when to sell and, most importantly, how much to wager. The tongue-in- cheek advice to “buy low, sell high’’ given to every trainee trader perfectly encapsulates the theory as well as the practical difficulty. The short half-life of traders shows that not everyone can follow the advice. Many can’t even discern “lows" and "highs", buying at the top and selling at the bottom demonstrated by the recurring trading blow-ups at banks. The reason why it is hard to put theory into practice is that we are not the rational calculating machines so beloved of academics. Every financial market transaction is a zero-sum game. The buyer believes prices will rise while the seller believes the opposite; both can’t be right. Rational analysis and decision-making on part of both cannot lead to such diametrically opposite views.
As with every game, winning at investing requires talent and skill. It also requires temperament. So how does one become a winner? Are we born with investing talent and temperament or can we acquire these? In most games, the belief is that champions are born, not made. For example, there is no debate that Sachin Tendulkar is a born batsman. However, investing is purely a mind game, more akin to chess than cricket or football. Here, the jury is still out on the born vs made debate. Judit Polgar, the best female chess player of all time and one of the strongest in the world, buttresses the case that champions can be made. She was coached by her father from the age of three and became a grandmaster at fifteen, the youngest at that time.
To answer the questions above and unveil the secret of success, we need to delve deeper into the investment decision-making process. Unfortunately, standard modern finance theory, with its beautiful mathematics and rational markets, is of no use. Behavioural finance offers a partial explanation by shedding light on the general biases that afflict our investment decisions. It talks about what is not done by successful investors and offers the hope that by training our minds, we can avoid succumbing to our natural instincts. However, it is akin to saying that we can live longer by eating healthily. We all know that, but most still find it difficult to abandon a “super-size me" diet. Behavioural finance offers little on why successful investors are able to keep their head while all about them are losing theirs.
The relatively new field of neurofinance, which combines neurology, medicine, psychology and finance, is trying to unpick the ingredients that make up the secret sauce of financial decision-making. The most interesting research focuses on the role of the neurotransmitter dopamine and the hormone testosterone.
Dopamine is involved in both motivation and the experience of pleasure in our brains. It is central to the functioning of the area of our brain that controls decision-making. The anticipation of rewards, including financial ones, leads to increased dopamine production and drives us towards securing them. The joy we experience once we have done so is again due to a higher dopamine level in the brain. This cycle is evolution’s way of making sure we continue to do battle in the survival of the fittest.
The implications for the investing process are clear—dopamine determines risk appetite. Higher the dopamine you require to feel happy, greater the financial risks you take and greater your drive in taking those risks (in the non-financial world, the requirement for higher dopamine levels has been linked to sensation-seeking behaviour such as skydiving). Research backs this link . In an experiment, individuals with a version of the Dopamine Receptor D4 gene causing them to require a higher dopamine level for a comparable response took more risk in a game of Bridge and an investment game. Interestingly, women with the genotype did not show the increased penchant for risk.
This difference between the sexes may be due to testosterone, the male sex hormone. Research points to higher levels of testosterone being correlated with higher risk taking. Testosterone, like dopamine, is also produced in greater quantities during a competition and in eventual victory. This interaction of dopamine and testosterone may explain higher financial risk-taking behaviour in male traders in contrast to female traders.
This research suggests that women have an inherent advantage in the investment game with their preference for lower risk-taking. Higher risk bets are counterproductive to success as they increase the likelihood of outsized losses from which there is no coming back.
However, men shouldn’t succumb to DNA fatalism and close their trading accounts just yet. Risk taking is only part of the picture. Evaluating which risks to take and which not to is just as critical to success. A win-loss ratio 60-40 is considered top class among traders. Therefore, success also requires an innate understanding of risk to be able to size wagers so that gains from wins are more than losses on wrong calls. Here, neurofinance research has more positive news for men. In the Bridge game experiment above, researchers found that men with a higher Bridge rank and more experience took higher risks where the likelihood of winning was greater. This suggests that factors beyond genetic makeup are important, too.
Therefore, successful investors need not be born, but it certainly helps if some of the traits are already encoded in their DNA.
Shashank Khare is an investment professional and writer. After studying engineering at IIT-D and business administration at IIM-A, he entered the world of credit derivatives before CDS became a four-letter word. Having successfully batted through the crises, he now indulges his passion for economics, finance and policy through writing and trading.
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