Investing on the Brain

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The Behavioral InvestorEditor’s note: The following is an excerpt (edited for style) from Daniel Crosby’s The Behavioral Investor. Crosby, Ph.D., will present tomorrow, October 3, from 9 to 10:30 a.m., at FPA Annual Conference. See him in the Grand Ballroom A-D.

Since, Crosby says, we are now entering the “Era of the Behavioral Adviser” it’s important for your clients to understand how behavioral aspects affect their investing. This excerpt will help them—and you—understand a little bit more about that topic.

“I am a brain, Watson. The rest of me is a mere appendage.” – Sir Arthur Conan Doyle, The Adventure of the Mazarin Stone

Thales of Miletus was the founder of the school of natural philosophy, a contemporary of Aristotle and one of the seven sages of ancient Greece. Tasked with inscribing short words of wisdom onto the Temple of Apollo at Delphi, Thales was asked what the hardest and most important task of humanity was, to which he replied, “To know thyself.” He was then asked the inverse and replied that “giving advice” was the thing least profitable to humankind that came very easily. Unfortunately for investors, Wall Street has done a great deal of the latter and very little of the former, sometimes with disastrous consequences. Fortunately for you, we are going to make that right here and now. If knowing oneself is the sine qua non of successful investing, there is perhaps no better place to start than the seat of knowing—the brain.

Old, Hungry and Impatient

“My Very Educated Mother Just Served Us Nine Pizzas.”

“In 1492 Columbus sailed the ocean blue.”

“Thirty days hath September, April, June and November…”

Mnemonics were invented by the ancient Greeks and have been used by students of all ages ever since. Whether they take the form of an acronym (RIP Pluto!), a rhyme or visualization, their longevity is a testament to their usefulness. As we begin our discussion of the brain is it applies to investing, I’d like you to remember three important truths about the brain by visualizing a tweed-clad septuagenarian in line at a steak buffet at 4 p.m. Just like the person you’ve imagined your brain is old, hungry and impatient.

It isn’t entirely fair to say that the brain is old inasmuch as our species is not that old in evolutionary terms, but our brains are certainly old relative to the modern milieu in which we utilize them. As Jason Zweig says in Your Money and Your Brain, “Homo sapiens is less than 200,000 years old. And the human brain has barely grown since then; in 1997 paleoanthropologists discovered a 154,000-year-old Homo sapiens skull in Ethiopia. The brain it once held would have been about 1,450 cubic centimeters in volume…no smaller than the brain of the average person living today.”

Our brains have remained relatively stagnant over the last 150,000 years but the complexity of the world in which they operate has exponentiated. Formal markets like our stock market are just about 400 years old. It would be a gross understatement to say that our mental hardware has not caught up to the times.

Evolutionary vestiges are apparent in the way that modern (wo)man invests even though the reasons for doing so have long since vanished. In ancient times, our ancestors would have stored excess food supplies from the spring and summer to be relied upon in the colder fall and winter months. Oddly enough, it would appear that saving and investing behavior ticks up today in the spring and summer months too, even when controlling for the impact of seasonality, past performance, advertising and liquidity needs. These effects have been observed in the U.S., Canada and even Australia where the seasons are nearly six months out of sync with North America. Although none of the ancient rules of living apply, modern investors inexplicably take risk in the spring and summer to be able to ride out the harsh fall and winter.

One consequence of our old equipment is that the brain can end up doing double duty, with primitive structures tasked with parsing risk and reward now charged with a job foreign to their design. Emotional centers of the brain that helped guide primitive behavior like avoiding attack are now shown by brain scans to be involved in processing information about financial risks. These brain areas are found in mammals the world over and are blunt instruments designed for quick reaction, not precise thinking. Rapid, decisive action may save a squirrel from an owl but it certainly doesn’t help investors. In fact, a large body of research suggests that investors profit most when they do the least.

The fund behemoth Vanguard examined the performance of accounts that had made no changes versus those who had made tweaks. Sure enough, they found that the “no change” condition handily outperformed the tinkerers. Behavioral economist Meir Statman cites research from Sweden showing that the heaviest traders lose 4 percent of their account value each year to trading costs and poor timing and that these results are consistent across the globe. Across 19 major stock exchanges, investors who made frequent changes trailed buy and hold investors by 1.5 percentage points per year.

Perhaps the best-known study on the damaging effects of our brain’s action bias also provides insight into gender-linked tendencies in trading behavior. Terrance Odean and Brad Barber, two of the fathers of behavioral finance, looked at the individual accounts of a large discount broker and found something that surprised them. The men in the study traded 45 percent more than the women, with single men out-trading their female counterparts by an incredible 67 percent. Barber and Odean attributed this greater activity to overconfidence, but whatever its psychological roots, it consistently degraded returns. As a result of overactivity, the average man in the study underperformed the average woman by 1.4 percentage points per year. Worse still, single men lagged single women by 2.3 percent—an incredible drag when compounded over an investment lifetime.

In an effort to understand how the brain processes patience, McClure and colleagues measured the brain activity of participants as they made a series of choices with either immediate or delayed monetary rewards. When the choices involved an immediate reward, the ventral stratum, medial orbitofrontal cortex and medial pre-frontal cortex were all used, parts of the brain implicated in drug addiction and impulsive behavior.

The prospect of an immediate reward provided a flood of dopamine that respondents found hard to resist. Choices among delayed rewards, on the other hand, activated the pre-frontal and parietal cortex, parts of the brain associated with deliberation. The results of the study suggest that our ability to control our short-term impulses toward greed are limited and that we are more or less wired for immediacy; bad news for the informed investor.

Your brain is primed for action, which is great news if you are in a war and awful news if you are fighting to retire. Scariest of all, there seems to be a causal relationship between activity in the emotional centers of our brain and making risky investment decisions. Researchers who evoke strong emotions in their subjects show consistently that their subsequent investment decisions are poorer and riskier.

Adding insult to injury, your brain is not only outdated and impatient, it is also the hungriest part of your body. Like an out-of-date iPhone your brain simultaneously manages to have limited functionality and even worse battery life. Although the brain accounts for just 2 to 3 percent of total body weight, it consumes as much as 25 percent of the body’s energy, even when we are at rest, according to the book Sapiens by Yuval Noah Harari.

As a result of this outsized appetite, your brain is constantly searching for ways to go into “energy saver mode” and not work quite so hard. And while this is a natural and even beautiful manifestation of the body’s harmony it also means that we do a lot of coasting off of the ideas of others and relying on cognitive shortcuts. A vast majority of the time these shortcuts do us no harm—you can drive home from work and barely notice—but they can be profoundly damaging when making investment decisions.

Your brain is a miracle unrivaled by even the most sophisticated technology, but it is a miracle equipped for a different time and place. After millennia of fighting famine, war and pestilence, we now live in a society of greater and greater ease that is increasingly left to fight psychological battles. Obesity will kill more people this year than hunger. Suicide claims more lives annually than war, terrorism and violent crime combined. Your brain is still fighting a war won eons ago and you must steel it for a new battle that rewards patience and consistency over speed and strength.

Daniel Crosby

Educated at Brigham Young and Emory Universities, Dr. Daniel Crosby is apsychologist, behavioral finance expert and asset manager who applies his study of market psychology to everything from financial product design to the creation of behavioral FinTech. In the summer of 2016, Dr. Crosby released his book, The Laws of Wealth, which was subsequently named the best investment book of the year by the Axiom Business Book Awards. His latest book, The Behavioral Investor, is available here.

 

One thought on “Investing on the Brain

  1. Information blog shared! Thanks for sharing it.

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