Your Money & Your Brain
By Jason Zweig
The field of neuroscience is the study of what happens inside thehuman brain when we take investment decisions and how the brain, in turn reacts to these investment decisions. While most traditional economic theories are based on the assumption that humans are capable of making rational choices, neuroeconomics attempts to explain why it really isn’t so. We all tend to buy things when they are cheap or on discount, but we often end up investing when the market is expensive and sell when it is cheap. Neuroeconomics suggests that investing decisions often lack logical sense but make complete emotional sense.
The way we interpret and respond to our surroundings is a function of our ‘Reflexive’ and ‘Reflective’ Brains. The reflexive system works so fast that you often finish responding before the conscious part of your brain realizes that there was anything to respond to. It acts as the brain’s first filter in registering things of importance and avoiding things that are not relevant. However, the reflexive system is also heavily fixated on change – you panic when a stock drops by 5%, but given its weight, your portfolio was affected by less than 1%. This number of less than 1% is registered and computed by the ‘Reflective Brain’. The Reflective Brain draws general conclusions from scraps of information, organizes your past experiences into recognisable categories, processes changes and plans for the future. However, the reflective system often ends up thinking for too long and missing out on opportunities or sometimes gives up thinking too quickly and lets your reflexive system to take over and take an emotional or spontaneous decision.
The idea is to use the best of both brains. Your reflective brain can conclude the strength of a company’s balance sheet but your reflexive brain can help you decide whether or not the workplace culture is going to sustain those numbers. You must know when the reflexive system will rule – in market frenzy, personal problem, and peer pressure – try to think through and get your reflective prowess back.
The book attempts to explain various emotions, how our mind is influenced by these emotions and how to keep them in check.
The mere thought of a gain can excite us much more than the actual gain itself. It is this excitement that further fuels our thoughts in one direction and makes us ignore adverse or unfavourable outcomes. As a result, our greed leads us to fiddle with risky investments despite knowing that larger odds are against us. A windfall gain in a particularly risky stock leads you to risk your money again expecting to be fortunate one more time. But this greed has higher odds of losing than winning again. If you are compulsively drawn towards risky investments, you might want to consider locking up 90% of your money in safe, well-diversified portfolio while playing with just 10%. That way, a total loss of your risky investments will not significantly impact your overall portfolio value.
Human beings like to be in control. That is why our reflective brain constantly seeks to decipher patterns in the randomness of the markets. Financial analysts, investment experts and market strategists try to predict the future based on certain indicators such as GDP growth, interest rates, fiscal policy, unemployment rate etc while there is enough historical evidence that these predictions have mostly been wrong. The right ones could simply be because of luck. These predictions have two problems. First, they assume whatever has been happening is the only thing that could have happened. Second, they rely too heavily on the short term past to forecast the long term future. Your most carefully researched analysis can go awry if a product fails or a CEO departs or a workshop catches fire. Hence, randomness always prevails and predictions seem futile. It is, therefore, better to control the controllable – your expectations, risk appetite and tolerance, expenses and taxes. Whenever an analyst makes recommendations, ask for evidence. If you are predicting something, take a break for some time andcome back to see if you still think that the prediction will hold true.
A survey of people with clean driving records found that 93% of them believed themselves to be above-average drivers. However, only 50% of them can be above average. Human beings tend to have positive illusions about their abilities. If our brain registered each of our shortcomings without discounting them, we would be in a state of depression.
The more we see something, the more we become familiar. The more familiar we become, the more confidence we have that we understand it. This is home bias. Therefore, people tend to invest more in the shares of their own company or the same industry. However, when the industry goes through a cyclical downturn or a shake-up, their regular income as well as their investments can turn sour.
The more a random structure exhibits consistency, the more we feel we are in control. Perhaps this leads us to buy stocks that have been rallying upwards for months now and avoiding those that have been sinking. However, chances are now high that the rally might just peak and invert whereas the slump might reach its trough and retreat.
In order to save your investments from the swings in your confidence, prefer owning the market by investing in index funds. There is a good chance that you have a bad stock in your portfolio and that it can crash anytime. Owning the market, however, reduces the impact of that one crash on your overall portfolio. You can avoid letting confidence overpower you by avoiding stocks or businesses you don’t understand, diversifying your portfolio, embracing your mistakes and evaluating if you really are better than average.
Most risk questionnaires by financial planners and wealth managers assume that the respondent is aware how much risk she is capable of taking. Mood swings or recent encounters and experiences can largely influence how we answer these questionnaires. A lot also depends on how these questions are framed. A diet conscious person is more likely to eat beef burgers if she were told that the beef was 75% lean and less likely if she were told it was 25% fat.
While making investments, we often don’t understand the instruments or stocks we are investing in. This is when we try to do what we see others are doing. Ideas are contagious. When internet companies were hot stocks in 2000, many people did not understand anything about the internet but they still invested. They ended up exposing themselves to risks they knew nothing about.
When dealing with risks take a time-out and indulge in some unrelated activity. See if your tolerance has changed post the break. Other ways could be to stop doing what you have been doing and alter the course of action, or write an Investment Policy Statement or try to disprove your conviction towards a stock.
Nobody likes wars because they kill thousands. However, historical data shows that suicides kill more people than wars. The more vivid and easily imaginable a risk is, the scarier it feels. Emotions can eclipse our analytical abilities. The presence of one risk can make other unrelated things seems risky, too. In the wake of September 11, the Consumer Confidence Index in the USA slumped 25%.The knowability of risk depends on how immediate or specific the consequences appear to be. Fast and finite dangers like train crash and skydiving feel more knowable than vague, open-ended risks like global warming.
When fear sparks in your mind as to the future performance of your investments, try asking yourself how the change in the externalities has really affected your stocks, do your prior convictions about the stock still hold true, are you simply following the herd – if not, let the fear pass and stay put with your investments.
In the fourth quarter of 2005, Google’s revenues were up 97% and profits 82%. However, Wall Street analysts had expected even better earnings. The negative surprise chopped off 16% from Google’s market cap within seconds. We tend to dislike negative surprises much more than we like positive surprises.
In order to break the cycle of surprises, do not try to justify an investment by saying everybody knows that. If everybody knows that, the price has already been factored in. Try looking for clues that the market seems to have missed. Never have too high hopes, so that you will not over-react. Try tracking the causes of surprises. By doing so, you will see and remember more surprises. The more we see something, the more our minds become accustomed to it and things will no longer be too surprising. That way you will have a more analytical way of looking at it.
It often happens that you are shown the historically great performance of an industry and you invest in it. However, your investment does not do well. This happens when the historical data only considers stocks that have survived and not the ones that liquidated. Adding the dead stocks to data shows you that outperformance is not certain. When someone shows you historical data, make sure it is adjusted for ‘survivorship bias’ or you could be in for a negative surprise.
Most people do not change their asset allocations throughout their lifetimes. Many others do not shift their funds across assets even when the allocation becomes lopsided. This is called mental inertia.
Countless research papers across economies have shown that people are more likely to sell low and buy high. As Daniel Kahneman puts it, when you sell a loser, you don’t just take a financial loss, you take a psychological loss from admitting you made a mistake. Also, the knowledge that you could have been better off makes you regret more.
Regression to the mean is the nature’s way of levelling the play field. A sector with impressive past fiscals is highly likely to experience a slowdown. Concentrating on just one stock or sector can amplify gains but also yield painful losses. We feel sadder when we lose than we feel happy when we gain. Diversifying across sectors can save you from the regret of being overly concentrated.
Almost everybody has regrets. In the hindsight, investors regret omission more than commission. When you sell a profitable stock that goes on to perform even better, you may feel bad about the lost opportunity of making more profit. But you cannot put a number on how much could that profit have been. However, you will certainly remember a deep loss that could have been limited by selling earlier. This is because you can count exactly how much you could have saved.
In order to avoid regrets or letting regrets get better of you, try to take lessons from losses you made and make rules for avoiding such mistakes. Your rules are part of your Investment Policy Statement. You must be able to tell yourself that you are not participating in market frenzy simply because it will be against your rules.
A happiness scale ranging from 1 to 7 was developed. On average, members of the Maasai ethnic group, who herd livestock on the arid high plains of Kenya and Tanzania score 5.7 on this scale. The Inuit, who live in the frigid wilds of northern Greenland, score 5.8 on this scale. The members of Forbes 400, the wealthiest in America, also scored 5.8 on this scale. These wealthy people were only marginally happier than an average American. The more money you have, the less extra happiness it buys.
Often, we feel buying that great car would make us immensely happy. When we buy it, we are happy. In a few months’ time, it becomes one of our many possessions. We imagine how wildly we would celebrate if the national team won a tournament. Whether win or lose, we go back to our normal lives only 2 days after tournament.
Managing emotions and expectations are just as important for being happy, as is managing finances. It is imperative to meditate – meditation activates neurons in parts of our brain that are necessary for being happy. Being happy also fires neuronsthat build strength in our immune system.
To be happy, avoid comparing your possessions and earnings with your friends or celebrities. Try to learn more even if the subjectis not about your profession. Open up your scope of observation and absorption of the things around you. Meet new people and socialize. Opportunities can come from places you could not imagine. Find ways of controlling your urge to splurge. Doing is better than having. Have more time for experiences than for possessions.
It’s simple: The happier you are, the longer and happier your life will probably be – and more money you are likely to have.