What happens to your brain when you invest?

Long-term investing demands patience. Our brains tend to prefer almost everything else.

The biggest threat to building long-term wealth in the share market could be your own brain. Not changes to capital gains taxes, not missing out on picking the next Nvidia and not the latest crisis rattling markets, but the instincts hardwired into the way we think.

One of the most famous psychology experiments helps explain why.

In the 1960s, researchers offered children a choice: eat one marshmallow immediately or wait a short time and receive two instead. Many couldn’t resist the temptation. The experiment became a powerful illustration of delayed gratification: the ability to give up a smaller reward today for a larger one tomorrow.

Investing asks us to pass a version of that test every day, but our brains aren’t wired for it. The mental shortcuts that help us make quick decisions in everyday life can become costly biases when we’re investing for the long term.

Would you rather have $100 today or $110 a year from now?

For many of us, the temptation is to take the money now. That preference for an immediate reward over a greater reward in the future is known as present bias, and it can create a real problem when investing requires us to do almost the exact opposite.

Research from Princeton, Harvard and Carnegie Mellon University found that our brains respond differently to rewards depending on when we receive them. Researchers scanned participants’ brains as they chose between monetary rewards available at different points in time, and found greater activity when an immediate reward was available than when rewards were delayed.

This can help explain why investing can be such a difficult trade-off. Spending $100 on a new pair of shoes gives us something we can enjoy right now. Investing that same $100 means giving it up today for a version of ourselves that may be some time away.

One way to fight present bias is to remove the decision altogether. Automating a regular investment shortly after you get paid means the money can be put towards future you before present you has the chance to spend it.

Humans hate losing money. The problem is we often hate admitting we’ve lost it even more.

That can be a dangerous combination for investors. Once an investment falls below the price we paid for it, selling can feel like locking in failure. So instead, we can convince ourselves to keep holding on until it gets back to the price we paid, which may never occur.

That is loss aversion at work.

Loss aversion describes our tendency to feel the pain of a loss more strongly than the pleasure of an equivalent gain. In investing, that can lead us to hold onto poor performing investments for too long simply because accepting the loss feels worse than moving on.

The market, however, doesn’t care what price you originally paid. A more useful question is: If you didn’t already own this investment today, would you still choose to buy it?

If the answer is no, holding on purely because you don’t want to realise a loss may be your brain making the decision for you.

Every investor has the potential to develop a soft spot for something they own. Once a company enters your portfolio, it can start to feel different from the thousands of companies sitting outside it. You may follow it more closely, become more familiar with its story and, without necessarily realising it, start to value it differently simply because you own it.

Psychologists call this the endowment effect, our tendency to value something more highly simply because we own it.

One of the most famous demonstrations came from Nobel Prize winner Daniel Kahneman and fellow researchers Richard Thaler and Jack Knetsch in what became known as the ‘mug study’. Half of a group of university students were given coffee mugs, while the other half received nothing. They were then asked how much they would be willing to buy or sell the mug for.

You would expect the two groups to value the mug at roughly the same price. Instead, those who had one wanted an average of $5.25 to give it up, while those without a mug were only willing to pay around $2.25 to $2.75.

If simply owning a coffee mug can almost double how much we think it’s worth, imagine what can happen to a company we’ve researched, followed and owned for years. That attachment can make it easier to overlook bad news or hold onto an investment after the original reason for buying it has changed.

Recency bias is arguably the most topical shortcut our brains are making right now.

The AI boom has helped drive share markets around the world to record levels and thrust companies that were once far from household names, like Nvidia, TSMC and SK Hynix, into the spotlight. At the other end of the spectrum, conflict around the Strait of Hormuz has created fears around global energy supply and given investors another geopolitical crisis to worry about.

Both have the power to influence our investment decisions and distort the way we think.

Recency bias is our tendency to give greater weight to what’s happened recently and assume those conditions are more likely to continue. After watching companies like Nvidia, SK Hynix and TSMC surge in value, it can be easy to believe they will continue to outperform.

Similarly, after weeks of headlines about oil prices and whether the Strait of Hormuz will reopen or not, those headlines can start to feel as though they will dominate markets for years to come.

One way to fight recency bias is to take a look in the rear-view mirror and see just how much the investing landscape can change.

In March 2016, the world’s 10 largest listed companies included Berkshire Hathaway, ExxonMobil, Johnson & Johnson, General Electric and Wells Fargo. Today, none of those five remain in the top 10.

Meanwhile, TSMC was only the 48th-most valuable company in the world, while Nvidia didn’t even make the global top 100. Fast forward a decade and Nvidia has become the most valuable company on the planet, while TSMC sits around sixth globally. To put Nvidia’s rise into perspective, the entire top 10 companies in 2016 were worth roughly US$3.7 trillion combined. Nvidia is currently worth more than US$5 trillion.

It’s important to keep in mind that the companies, industries and stories dominating headlines right now will look completely different in a decade, and ensure that recency bias doesn’t cloud your judgement as a long-term investor.

Unfortunately, knowing about cognitive biases doesn’t suddenly make you immune to them.

You’ll still be tempted to spend money today rather than invest it for the future. Realising losses will still hurt more than hoping an investment will bounce back. You’ll still become attached to investments you already own, and whatever is happening in markets right now will likely feel more important than it probably is.

You won’t be able to eliminate those instincts. But you can build an approach that makes it harder for them to dictate your decisions.

That might mean automating your investments so you have fewer opportunities to buy that extra pair of shoes. It could mean asking whether you would still buy an investment today rather than focusing on the price you originally paid. Or it might mean reminding yourself how dramatically markets can change before making a decision based on the latest headline.

Sometimes, the best thing you can do as an investor isn’t finding more information, putting through more trades or trying to predict what markets will do next. Instead, recognise when your brain is getting in the way and have a system in place to overcome it.