Stock Picking is sexy, but Asset Allocation is key

“An undervalued gem with massive potential – click to find out more!” Do heading like this intrigue you and tempt you to click on the link to read the rest of the article? If you have succumbed to these temptations at some point in your life, you are perfectly normal.

Our human brain has two systems to process information for decision-making – a reflective route and a reflexive route. A reflective route is logical, analytical, and methodical, while a reflexive route is quick, impulsive, and intuitive. The reflexive system is located in the basal ganglia and amygdala, which are the more primitive parts of the brain. When words like “massive potential” is flashed in front of you, it can trigger a burst of anticipation in the reflexive part of your brain. Combine that with a suddenly rapidly rising share price and the likelihood is that you may just throw caution to the wind and join in the party. Maybe the word has gotten out of its undervaluation, I better get in before it is too late, you may reason to yourself.

If the performance of the stock turns out to be lackluster subsequently, or worse still, money-losing, you may then abandon your attempt at “investing” subsequently. At least this is what happened to me in my younger days. There was no online brokerage then and I had to call my broker to purchase the shares. As the broker rattled off the price of the share and it kept going up, I could feel the rush of adrenalin in my vein as I was suddenly determined to get the share at all cost. The Asian financial crisis imploded soon after and I avoided the stock market for years.

A better way to make long-term investment decisions will be to rely on the reflective part of the brain. The reflective system is located largely in the prefrontal cortex, which is critical for many complex human activities. A reflective system can draw general inferences and conclusions from information, formulate theories and plan for the future. By recognizing the tendency for our reflexive system to take over under times of stress, we can harness our reflective system and put in place certain defenses that made us less susceptible to our primal instinct.

Drawing up an asset allocation plan is an example of the defense we can put in place. It is a plan for sums we intend to put aside for investment – specifying the percentage we should allocate to stocks, bonds, and cash respectively. Yet talking about asset allocation is hardly exciting, unlike discussions on hot stocks and hot tips, even though numerous research has concluded that asset allocation accounts for most of the portfolio’s return over time.

The stock market can be a dangerous place to have excitement. Having a plan in advance is crucial for meaningful results.