“Your Money and Your Brain”

          It’s not that we are intellectually deficient, or that we are not capable of being rational. It’s just that when it comes to emotional intelligence, we have no idea. Jason Zweig’s new book “Your Money and Your Brain”, which will be out in a few months, examines the reasons why most investors, including professional investors, are so often their own worst enemy.

          By examining how the brain works, we can learn a great deal about investing. Not just how groups of investors behave but also how we ourselves react as individuals.

          Here are the key points I took from Jason Zweig’s new book:

          1. All investors tend to underestimate emotional hijack.

          2. Preparation reduces panic, and maximizes opportunity.

          3. The emotional part of the brain is highly active in short term decisions, but much less engaged in long term decisions, which are more abstract to most people.

          4. Expectations and experience significantly influence our behavior in ways we may not be fully aware of.  

          5. Your brain tries to protect your tender sensibilities.

          6. Be systematic and humble about the veracity of your own “expert” opinion.

          Emotional Hijack

          Much of what this book reveals rings true. It starts from the point of view that money is closely linked to the risks and rewards that are important to our basic survival. Losing money is processed in the brain in much the same way as meeting a rattlesnake. On the other hand making money is almost indistinguishable in the brain from getting a narcotic. It’s incredibly thrilling at a physiological level.

          Unfortunately, these incredibly powerful emotional forces, often described as fear and greed, push us towards disastrous investment behavior. As we all feel the joy of making money in a rising market we feel induced to buy more and more at ever higher prices. At the same time we hate the losses when the market falls and want no part of it. At some point we would rather take the loss to relieve ourselves of the emotional pain.

          Don’t believe this happens? Just take a look at mutual fund flows. Flows into equity funds follow market price action all the time. This behavior results in tragically poor results for most investors (see Market Notes 10).

          From a safe distance we can all see that buying when the market is high and selling when the market is low, is not a successful strategy. Nevertheless we all imagine that because we intellectually understand this, that we will be somehow immune from the emotional impulses when the time comes. We forget that so often in the heat of battle that our emotional responses are closely attuned to our survival instincts, and will trump our intellectual thinking far more often than we like to believe.

      Preparation reduces panic and maximizes opportunity

          Unless we have confidence in a consistently applied plan of action, set out in advance, and we stick to this plan systematically, then sooner or later the markets will test our investment approach, by releasing very powerful emotional doubts and questions, and possibly involuntary and uncontrollable choices of action.

          This is why it is so important to understand how an investment plan works and be able to trust it through adverse conditions, not just at an intellectual level but also at an emotional level. Part of the process is to check the robustness of your portfolio. What are the risks and probabilities of different outcomes? How diversified are you? Imagine if extreme conditions were to occur. What would happen to your portfolio and could you live with this outcome? What discipline do you have to your individual positions? Do you understand what you own?

          By adopting a comprehensive risk management plan, with a buy and sell strategy, we should be able to place limits on adverse outcomes and be reassured that damage will be limited, and hopefully avoid panic.

          It is also a great advantage to understand underlying values. If you are confident that you own long term underlying value, holding positions is so much easier. Indeed in troubled down markets, the great advantage falls to those who understand intrinsic value. This enables the value investor to buy assets at an increased margin of safety while others panic. Preparation and understanding increase confidence a great deal.

          Short term decisions are more emotional

      At Princeton a study used MRI scans to look at people’s brains while they were making different kinds of choices. The conclusion they reached was that the emotional part of the brain is highly active in short term decisions, but has almost no involvement in long term decisions.

          Long term investment decisions are generally the focus of value investors. This form of investing takes a high degree of patience and courage, and is rarely found in practice. However, for those who can do it, there seems to be strong evidence that emotional hijacking may well be minimized, which may reinforce the advantage of adopting a value style.

          Although it may not be universally true this idea seems to be supported by the observation that equity managers that are universally regarded as having great track records, tend to take a long term perspective. Perhaps the lack of emotional inference is a key factor in their favor.

      Expectations and experience

          As for any animal, survival can only be achieved by being alert to potential dangers, whether real or imagined. This makes us keenly alive to events that differ from our expectations. Any departure from our expectations tends to make us highly alert. This is an automatic defense mechanism, as we need to quickly process what changes could have occurred to reassure us that there is no new danger. In consequence there is a strong tendency to exaggerate new information.

          This is why we so often see short term over-reactions in markets. Rushing to judgment and instantaneously placing a trade as each new development occurs is understandable, but as markets may be biased to over-react, there may well be a disadvantage to rapidly responding, particularly in a highly charged fast moving market, in which there is little time to fully process new information and reach a considered decision.

          From a more individual perspective our own expectations will be set to a large extent from our own individual experiences. The “once-burned, twice-shy” experience is very common, but there are a whole range of experiences that may well come into play that it turns out we may not be even aware of.

          For example the author submitted himself to a test in which he was asked a whole range of questions. The author believed that he had remained calm throughout, but that is not what the physiological sensors showed. His pulse had quickened, his palms had sweated, and a range of measurable physiological responses had occurred.

          This last observation is highly disturbing as it suggests that we may well not even know the extent to which we are being influenced by experiential factors, and therefore whether we are in an optimum state to make the best rational decision.

      Rationalization

      There is a strong tendency for us all to want to believe certain things that suit us. As such we are masters at rationalization. In other words our brain helps us find a way for us to believe what we want. Whether the logic we use is objectively valid can be far more questionable. We do not willingly seek out unappealing conclusions. Indeed we may have to force ourselves to do this, in order to achieve objectivity. In consequence we have to realize that we have considerable susceptibility to self-deception.

          A highly valuable check to the validity of our own decisions and judgements can fortunately be derived by developing models and systems of how markets really do behave and checking how well these approaches have worked over time. By developing our own tool box of tested models we are likely to get much closer to objectivity in our decisions. Indeed this approach also enables us to find out where we can add the best value in our decision-making, as well as where the best opportunities are likely to be found at any time.

 

 

          Conclusion

      There is still far more that we don’t know about the brain than what we do know. However, the insights provided by Jason Zweig provide a number of important points that should help raise our self awareness of the traps we can so easily fall into as investors. It also provides some excellent guidance about the areas where our investment decisions may be at their most productive.

          The analysis seems to confirm my own experience. Short term trading is very exciting and this makes it highly appealing to many. However, over twenty years and more of meeting traders and investors I have met far more successful long term oriented value investors, than successful short term traders. Having a strong bias in favor of value, being consistent and systematic probably sounds dull to most people, but personally I would rather maximize my investment returns than my excitement when I am investing.

          Jason Zweig’s book seems to add a great deal of explanation as to why long term value investing and systematic approaches may work much better than so many other investing styles. Simply put, they have the benefit of saving ourselves from flaws inherent in our own hard wiring.

          Then again, perhaps I just want to validate my own opinion!

 

 

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