A confluence of market psychology, neuroscience and economics, the emerging field of neuroeconomics seeks to explain what's happening inside our heads when we make investment decisions. If we can understand how our biochemistry governs our trading impulses, we can become smarter investors. By counseling the volatile marriage between our analytical and reflexive neurons we can overcome our biological programming and become savvier investors. The Bull's Mike Dojc has an illuminating tête-à –tête with Jason Zweig, author of Your Money & Your Brain: How the New Science of Neuroeconomics Can Help Make You Rich
What would you say is the most fascinating big picture insight this emerging science has revealed about investor behavior?
We don't realize how often we're in the grip of what psychologists call unconscious bias. We rarely realize the real reason for a lot of the things we do. I believe it was JP Morgan who said everyman has two reasons for everything he does: the reason he says and the real reason and neuroeconomics has done a lot to expose the real reason, the real core functions in our brain that are driving our decisions.
It's not just that we're making decisions for reasons we are not aware of, it's also that often we are feeling emotion that we are not aware of and those two things combined are so important for investors and corporate managers to realize. We always think we're thinking when we make decisions and at least as often we're feeling and we're telling ourselves that we're thinking.
Can we extrapolate then that humans are hardwired biologically to make poor financial decisions-can we blame poor investing decisions on the circuitry of our brains?
In a lot of ways I would agree with that. The human brain is a pattern recognition machine. It is a very efficient mechanism for identifying simple repetition. Unfortunately in the modern financial markets simple repetition is not a very common phenomenon. The market is much too efficient to permit things to be that predictable. If there really was a stock that was guaranteed to go up every single year then everybody would buy it, it would cease to be cheap, and it would stop going up. But the brain is designed to think there are lots of investments like that. So, we pursue them and get overexcited by reward, over-alarmed by risk and tend to overreact both on the upside and the downside.
Despite ample evidence to the contrary why do many people believe they can predict future stock movement based on past performance?
It's largely because automatic pattern finding [is ingrained] in the brain. It's also because people tend to distort their own predictive track record. We have a much more sticky memory of the times we were right then the times we were wrong. Being right is a very profound emotional experience in the brain and making a correct prediction of reward is itself a kind of reward to the circuitry in the brain. So when you think back to the times you were right those memories are really burned into your brain and rise to the surface very vividly. Your neurons are stimulated by the reward of having been right before and you actually become addicted to that sense of being right.
So the experience of being right in the past has an almost narcotic effect?
This is what I call the prediction addiction. There is an almost perfect correspondence in the brain between someone who is a drug addict about to take a hit of cocaine or morphine and someone who has been predicting stock returns, has been right and expects to be right again.
If we could somehow suppress the emotional component of our brain would be much more effective traders?
Emotion in investing is like everything else in life. In moderation it's a good thing. In excess it's really bad. If someone were completely unemotional and completely rational in the economic sense of the term, I doubt that he or she would actually be all that good an investor. Charlie Munger was at a dinner in L.A. and the woman he was sitting next to turned to him and said 'Mr. Munger you're famous for being Warren Buffet's partner and a great investor, tell me what's your secret, what made you this billionaire genius investor? Munger who is a man of few words responded 'I'm rational' and went back to eating his salad. I think that's part of the story but it's not the whole story. What great investors do is not to turn their emotions off but to turn their emotions inside out. Warren Buffet has often talked about being fearful when everybody else is greedy and fearful when everybody else is greedy. The greatest money is always to be made in the long run by short selling everybody else's mood. So when everybody else is positive you should be skeptical at the least and probably negative. When everbody else is negative you should be very positive. The best way investors can do this is by actually tracking their emotions over time.
What can we hope to learn from keeping an emotional investment diary?
There is information in your emotion. The trick is it is usually contrary information. This past July most people were euphoric about how well the market was doing and then in August most people were miserable. If investors took notes and looked back on those feelings in September they would be able to realize that they were euphoric at the wrong time so maybe they were miserable at the wrong time too. The purpose of this is to become more mindful of your decision making process and to be more introspective in order to understand why you are doing things. Whenever you make an investing decision you should keep a record of why you made the decision. So if you buy a stock, write down three specific reasons, your scientific hypothesis if you'd like, of why this stock is going to go up. And also include a probability of how likely you are to be right and a timeframe on how long it will take to be proven right. When you look back later you will be able to see if you were right for the right reasons or if you were just lucky. Another technique you can use is to jot down a couple sentences at the market close each day about how you are feeling about your portfolio. It can be as simple as 'I'm feeling neutral' or 'I'm happy.' It's a very good way to become more mindful. I actually know of people who enter their emotions in an excel spreadsheet and regress them over time against a stock index.
This Article originally ran in the Fall 07 issue of The Baystreet Bull
Copyright © Mike Dojc 2007