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Your Brain and Investing

Most investors are their own worst enemy.  They buy high and sell low, allow the herd to dictate their decision-making and get caught up in the day-to-day movements of the market.  The relatively new field of neuroeconomics, which studies how people make choices, helps explain why the market is anything but rational. 

BetterInvesting recently spoke with Jason Zweig, author of the new book Your Money & Your Brain, about his research on neuroeconomics and what we can do to keep our worst impulses in check.  Zweig is a senior writer for Money magazine and was also the editor of the revised edition of Benjamin Graham’s The Intelligent Investor.  He serves on the editorial boards of Financial History magazine and The Journal of Behavior Finance.

 How did researching this book change your views of investing?

The first and most important thing that came out of this is that it’s very comforting to find new proof of old truths.  There’s very little I’ve changed about my own investing approach and not much I’ve changed about the investing advice I continue to give people.

The second principle that I took away from it is that people are unaware of how great an influence the unconscious mind holds over our decisions.  I tell the story in the book about a doctor who buys a stock just because it has the same ticker symbol as his initials.  There’s actually a whole field of research into this area, which psychologists call implicit egotism.  It’s the idea that completely unconsciously, people favor things that are closely associated with themselves.

We often don’t know the real reason we’re doing things, and that can lead us to think we understand our decisions when in fact they never really were decisions in the first place.  They were just ideas that came to us, and we didn’t really know why, but they felt right and we acted on them.  This is what (author) Malcolm Gladwell calls “blink.”  That’s a very good idea if you’re in a battle and you’re being shot at.  If you think you should duck, you should.  But it’s probably not such a good idea when you’re investing.

One of the main points of the book is that investors can solve a lot of the problems they’ll have to overcome by shutting out the noise.  What are some of the negative effects of the instant availability of information?

If you’re hooked up to a machine that monitors your bodily functions and you watch an online stock ticker going down with a lot of red arrows, or you watch some CNBC show with some funny-looking man waving his arms and screaming, your blood pressure will go up, your pulse will climb, you’ll start breathing faster.  Your temperature will rise, you’ll turn red in the face, you’ll sweat.  Depending on how severe it is, you might be aware of the anxiety you’re feeling.  Or it might not register in your conscious mind; it might just be a slight uptick in your body tension.  But all it takes is a tiny change in your normal body state to skew your response.

If we take someone who’s mildly upset and ask him to sell a stock, he’ll accept a lower price than someone who’s in a neutral or positive mood.  The evidence is overwhelming that paying attention to negative news does change your body, and when your body changes, your brain changes with it.  This naturally inclines you toward making short-term-oriented decisions, panicky decisions and bad decisions.

It’s hard to say what the single worst thing an investor can do is, but my vote would probably be to pay close attention to the market news.  Even if it’s good news, it will prompt you into doing things that are bad for you.  And if it’s bad news, it will prompt you into doing things that are terrible.

Your underlying message seems to be to just follow a company’s fundamentals.

You really have to ask yourself, “What is the information that I would get from instantaneous sources that no one else would get before I got it?”  Everyone else is watching CNBC, too.  Everyone else can click on the same market website that I can.

There are a few reasons people feel the urge to do this.  First, we all believe that being informed is better than being uninformed and that information must be inherently a good thing, because we know ignorance is bad.

Second, we tend to ignore what other people are doing.  It’s very hard to remember that when you turn on CNBC, there are hundreds of thousands of other people watching at the same time.

We’re also afraid of what will happen if we don’t stay current.  But there are experiments showing that when people do stay closely informed on what’s going on in their company, they actually earn lower returns.  Because whenever you get news, you assume that it’s worth knowing, and because it’s worth knowing, it must be worth acting on.  So if the news is good, you buy, and if the news is bad, you sell, when you actually would be much better off buying and holding (because of all the transaction costs from trading).

The thing to remember is that for the typical large-cap stock, the kind of company likely to be owned by BetterInvesting readers, through any market website you’ll see the price change three to 10 times a minute.  Those one- or two-penny changes will register with you, and any time you see motion, your brain is designed to extrapolate from it. 

So if a stock has two upticks in a row, you will expect a third.  It’s the watching that tends to lead to doing.

Think back to the days when our parents were investing.  Unless people lived in a major city, or unless they subscribed to The Wall Street Journal, they often would go for an entire week without being able to update a stock price.  I distinctly remember in the 1970s, my dad buying a stock and awaiting the following Friday’s newspaper, because that was the one with the stock prices.

Here’s a simple test:  If more information were good for people, then clearly, the returns of the average investor should go up as more information becomes available.  But in fact, that’s not what we’ve seen.

In my opinion, the single biggest advantage individual investors have over professionals is that they don’t have to play that game.  They can choose to say, “It’s 1:13 in the afternoon, and I don’t care what my stock price is.”  If you run a mutual fund, you can’t do that.

Does having a system help us avoid the pitfalls you describe in the book?

Absolutely.  Probably the best sentence ever written on investing is Benjamin Graham’s old saying, “The investor’s chief problem — and even his worst enemy — is likely to be himself.”  That’s really true.  Emotion isn’t always bad, but emotion that’s unchecked by reason usually is bad.  It’s nice to have some emotional input into your decisions ... but if all you’re doing is going on your gut feeling, you’re highly likely to be making a mistake.  You need to mix your emotions with some analysis.

The way you prevent yourself from being your worst enemy is by putting some policies and procedures in place.  What you can do is say, “Well, it’s Jan. 1 or July 1, that’s the time of year when I do my rebalancing, and my target allocation of stocks is 70 percent to 80 percent.  Right now I’m feeling nervous, so I’m going to go to the low end of my range.”  If your gut feeling tells you the market is cheap, then you can go to the high end of your range.

But the important thing is that you have a range and you honor your own procedures; you don’t break your own rules.  Because any time you break your own rules, you’re probably making a mistake.

But at some point, you have to go with your gut, because no system can tell you everything you need to know about a stock.

That’s true, but the key here is to make as few decisions as possible.

It must be hard to maintain discipline when you see the market rewarding stocks that you won’t buy.

It’s very hard.  That’s why it’s important to have an investing policy statement, which is the starting point.  This essentially explains what your money is for and how in general terms you’ll go about achieving those goals.

But you also need something more specific, a contract with yourself.  It needs to be in the form of a checklist, and it needs to say, “I will do this” and “I won’t do that.”  You should have it witnessed by a family member or a friend, and you should try to form a little support group of like-minded people.

The important thing is to track your decisions.  If — heaven forbid — you break any of your rules, at the time you’re breaking it you have to write down why you’re doing it.  Later on, whether the result is good or bad, you have to go back and look at what you said you were trying to accomplish and see whether breaking the rule was worth the trouble. 

My prediction is that at least 80 percent of the time, you’ll be sorry you broke your rule.

Common Errors in Decision-Making

The following are some common biases people have, as identified by Max Bazerman of the Harvard Business School.  This is adapted from a Babson Staff Letter of Nov. 11, 2005.  For the complete article, see BetterInvesting’s February 2006 issue.

Availability: Making decisions on the vividness and recency of information.

Irretrievability: Failing to think beyond a preconceived notion.

The confirmation trap: Unconsciously searching for supporting evidence that we made the right decision.

Insufficient anchor adjustment: Seeing a situation very similar to a past event and interpreting it to mean the same thing will happen this time around.

Hindsight: Changing our evaluation of something or someone after events play out, when we have perfect knowledge.

Regret avoidance: Tending to feel more regret in an act of commission vs. omission.  Buyers feel much more remorseful about committing to a purchase and having to live with the decision (be it a good decision or not).

Internal escalation of commitment: Increasing the support of an initial decision over time.

Keys to a Balanced Investing Life

Take the global view.
  Use a spreadsheet that emphasizes your total net worth — not the changes in each holding.

Hope for the best, but expect the worst.  Diversify and learn from market history to help keep you from panicking.

Investigate, then invest.  A stock is a piece of a living corporate organism.  Study the company’s financial statements.

Never say always.  No matter how sure you are that an investment is a winner, don’t put too much of your portfolio in it.

Know what you don’t know.  Don’t believe you are already an expert.  Ask what might make an investment go down; find out if the people pushing it have their own money in it.

The past is not prologue.  Never buy a stock just because it has been going up.

Weigh what they say.  Before trying any strategy, gather objective evidence on the performance of others who have used it in the past.

If it sounds too good to be true, it probably is.  Anyone who offers high return at low risk in a short time is probably a fraud.

Costs are killers.  If you want to get rich, comparison-shop for trading costs and trade at a snail’s pace.

Eggs go splat.  So never put all your eggs in one basket.

Adapted from Your Money & Your Brain (Simon & Schuster, 2007) by Jason Zweig.

Adam Ritt, Editor, BetterInvesting Magazine.

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