Wall Street Journal columnist Jason Zweig has written on just about every topic imaginable when it comes to the world of personal finance. His book Your Money & Your Brain covers a gamut of emotions and biases that we’re likely to experience when dealing with money. The major theme, as Zweig puts it
“…our investing brains often drive us to do things that make no logical sense. That does not make us irrational. It makes us human. Our brains were originally designed to get more of whatever would improve our odds of survival and avoid whatever would worsen the odds. Emotional circuits deep in our brains make us instinctively crave whatever feels likely to be rewarding–and shun whatever seems liable to be risky.” [1a]
In other words our minds are still quite primitive. The mental processes and emotions that evolved to help our ancient ancestors survive have resulted in some unintended consequences when it comes to dealing with modern day financial decisions. Using a combination of psychological evidence and easy to understand examples Zweig takes readers through the progression of emotions that they are likely to experience when managing their finances and investments
More often than not these emotions stem from the way that we process information. When we process information about the world around us our minds work in two distinct ways. The first is the fast acting reflexive mind. This way of thinking is driven by emotions and allows us to respond quickly to various situations, like a fight-or-flight response. The second way of thinking engages our reflective mind, which is slower at processing information but provides more rational, logical thought patterns. The major challenge we face as humans is getting these two thought patterns to work together as each have their advantages and disadvantages.
Our mind treats the financial rewards that we earn through investment activities much like other rewards (food, drink, shelter, sex, etc.). The anticipation of these rewards is processed reflexively causing us to experience a sense of euphoria–what we commonly refer to as greed. This excitement allows us to focus on the task at hand. However, if and when we actually receive the reward brings about a different result. Getting the actual prize doesn’t feel nearly as good as anticipating the prize.
Trading stocks based on what we feel–anticipating a big fat gain–is one such example, and it didn’t work out well for me. Allowing our emotions to drive our short-term actions can lead to irrational behavior. The outcome could be greatly improved if we take a pause, step back, and engage our reflective mind. A closer examination of the facts tells us that stocks fluctuate up and down, but over long periods of time the market always rises.
It’s not uncommon for a stock’s price to change as often as a thousand times in a single trading day, but in the world of real commerce, the value of a business hardly changes at all on any given day. [1b]
Recognizing these long-term outcomes is inherently difficult for humans to do naturally. Our primitive brains have not yet evolved to the point of being able to understand them. Furthermore, we have a tremendously difficult time when it comes to discerning what events are truly random. Our caveman brains were built to make the most out of small amounts of data. As a consequence we have a tendency to look for patterns in data even when they don’t exist. Market “technicians” that talk about resistance levels and head-and-shoulder chart patterns are a few examples. They think they can use these patterns to predict future gains or losses when in reality they’re more than likely fooling themselves.
Why do we look for patterns and form expectations around them? Our reflexive mind evolved around detecting patterns in nature. It leaps to conclusions unconsciously and automatically. Thunder follows lightning. Strong winds cause tree branches to sway. But there’s a big difference between recognizing patterns in nature and thinking that we can recognize patterns in financial markets. Buying a “hot stock” with a recent pattern of strong positive performance on the expectation that it will continue to increase in value usually doesn’t end well. Most recently the dot-com bubble of the late 1990’s and housing bubble of the mid 2000’s both demonstrated that nothing goes up forever. What has done well in the recent past seldom does well in the near future.
Continuously rising markets, such as those we might see in a bubble can create a sense of familiarity and comfort around the heady positive returns. As we spend more time around something we slowly become more comfortable with it and develop a positive attitude towards it. We seek familiarity and comfort as a way to avoid danger. Ironically, the feeling of confidence we develop during market bubbles can turn into overconfidence and end poorly.
In late 1999 and early 2000 Brad Russell, an air traffic controller in New Hampshire, invested in a hot Internet stock called CMGI Inc. At first he nibbled, buying just a few shares. The stock shot straight up; he bought more; it went up more. Now Russell bought over and over and over again, until he had jumped into the stock with at least ten separate purchases, at prices up to $150 a share. At the peak, he had 40% of all the money outside his retirement fund in CMGI stock. Then the Internet bubble burst, and CMGI came crashing down like a boulder knocked off a cliff. Russell finally sold when the stock hit $1.50, a 99% loss at its worst. [1c]
We exercise confidence through familiarity in a number of other ways: owning shares of stock in the company we work for, only investing in companies located in our country of residence, or expecting the mutual fund we own to outperform the broader market (most don’t). These are all examples of home bias, where we feel that the things most familiar to us, or things that we own, tend to be the best.
One of the benefits of our reflexive mind is dealing with risky situations. It is able to identify danger quickly and put our body into motion to get to safety. For our ancestors, under-reacting to real risks could be fatal while overreacting to risks that turned out to be imaginary was harmless. Zweig refers to this behavior as the “better safe than sorry” reflex. But this tendency to react quickly can be disastrous when dealing with financial markets. Selling when the market is going down or has reached a low point will more often than not lock in a permanent loss.
Engaging our reflective mind and thinking logically can lend a helping hand. When the market has declined the price has dropped. Shares in ownership of companies are now selling at a discount and can be had for a more attractive price. Under these circumstances we should be buying, not selling. It is often said that the stock market is the only market where everything goes on sale and everyone runs out of the store.
A quick reaction to declining market prices is often driven by a feeling of fear. Fear is controlled by a region of brain called the amygdala, which helps us focus on anything new or fast changing. When responding to these stimuli it also triggers the release of chemicals such as norepinephrine and corticosterone which assist the body in physically taking action.
The fear that we feel when exposed to risks is governed by the concepts of “dread” and “knowability.” Dread refers to how controllable or potentially catastrophic a risk appears to be while knowability depends on how immediate or certain the consequences are to occur.
Dread and knowability come together to twist our perceptions of the world around us: We underestimate the likelihood and severity of common risks, and we overestimate the likelihood and severity of rare risks–especially if we have never personally experienced them. [1d]
The amygdala’s role in helping us detect novel stimuli is not without benefits. If we failed to detect changes in our environment we would likely continue to make mistakes. The mistakes we try hardest to avoid are those with important negative consequences–especially losing money.
Sometimes we make mistakes and the outcome is good, other times it can lead to a loss, and the way our brains respond is different in each case. Mistakes that result in a reward seldom draw a response from our brain; however, a mistake that produces a loss causes a region of brain called the ACC to fire intensely.
With these insights, we can finally understand why stocks that beat Wall Street’s expectations go up an average of 1%, while those that come up short lose an average of 3.4%. [1e]
In other words a positive surprise elicits a much milder response than a negative surprise.
A positive financial surprise can also come in the form of a windfall. Those once-in-a-lifetime receipts of large amounts of money from things like inheritances, bonuses or lottery winnings. How we manage these large sums of money depends largely on how they make us feel. A bonus makes us feel like we earned the money and we’re more likely to save it. Winning the lottery gives us a sense of having money we never thought we would have and we tend to spend it, quickly.
Spending the entire windfall will more than likely cause some regret. Large sums of money present a lot of choices. When we think about what we could have done with the money rather than what we actually did we’re engaging in counterfactual thinking. We imagine what might have happened rather than what actually did happen.
The regret we feel regarding investment decisions is no different. Making investment decisions that turn out to be losers becomes even more painful when we consider the alternatives that went on to do better. The feeling of regret only grows when we hear how successful others have been.
We’ve all had that envious feeling when others do better than us. The feelings we derive from money in part depend on how much money those around us have. Small amounts of envy can be beneficial as it pushes us to pursue greater things and keeps us hopeful. When envy is taken too far we end up desiring possessions or experiences that we think will make us happy, but turn out not to.
Likewise, the pursuit of wealth for the sake of wealth can have a negative impact on our happiness–being rich doesn’t make people happier. Make more money and you’re likely to end up in the same emotional place wishing that you had even more. Surveys of various groups of people around the globe have supported the notion that money doesn’t buy happiness. Various groups, including the Forbes 400 list of wealthy Americans, the Inuits of northern Greenland, the Amish, and the Maasai livestock herders of East Africa all report very similar level of happiness regardless of wealth or lifestyle. We think money will lead to a happier life, but it seldom does.
On the topic of happiness, here’s a quote from the book that I think is appropriate to close on
…no matter how much or how little money you have, you can use it to lead a happier life if you understand the limits of what it can do for you and the power you can exert over it with self-control. [1f]
1. Zweig, Jason. Your Money & Your Brain. Simon & Schuster. New York, NY. 2007.
(a) p. 3
(b) p. 32
(c) p. 106
(d) p. 158
(e) p. 181
(f) p. 228
What I’m Reading
Annuities as an Alternative to Shaky Markets? Not So Fast (New York Times)
Abundance (Josh Brown)
On Investment Charlatans (David Merkel)
The Bernstein Curve (Tadas Viskanta)
The Evolution of Good Investing Ideas (Morgan Housel)