It has been more than a year since I read Your Money & Your Brain: How the New Science of Neuroeconomics Can Help Make You Rich. This new science, using advanced imaging of the brain, has actually identified how and where we process our thoughts as investors.
The author, Jason Zweig, has been a financial journalist since 1987 and is currently writing the personal-finance column in The Wall Street Journal. I had the pleasure of meeting him in 2007, before his book went to press, at an advisers conference.
After a few opening remarks, he quickly pulled a rubber chicken from behind the lectern and threw it at the audience. Everyone at least flinched, including me, while several others gasped with fear.
His point was to illustrate how we all use our “reflexive” part of our brain.
The reflexive part of our brain is the largest part, and it has developed over many millions of years. When prehistoric man saw a lion jump from a bush, his immediate reaction was to run for his life.
Research has shown this older, primitive and more-developed part of our brain tends to override a second part of our brain, which is the “reflective” or analytical part, which has been developed more recently, in modern times.
One of the researchers’ findings identified how financial losses are processed by the same part of the brain that responds to mortal danger. I suppose this is one of the reasons why, in March 2009, many investors were scared out of the stock market as the market approached 12-year lows.
Another part of the brain has been seen to light up when we make a prediction and it comes true. This part of the brain also responds to sexual pleasure.
Unfortunately, humans can be pretty dysfunctional when it comes to making predictions. The book describes an experiment where rats and pigeons were better predictors than humans.
In the experiment, researchers flash two lights, one green and one red, onto a screen. Four out of five times, it’s green; the other time, the red light flashes. But the exact sequence is kept random.
When rewarded for correct picks, rats and pigeons quickly discover the best strategy is to always pick green, guaranteeing an 80 percent correct-pick rate.
Humans, however, tried to anticipate when the red light would come on. This misguided strategy, on average, leads people to pick the next flash accurately only 68 percent of the time.
Stranger still, humans persist in this behavior even when researchers tell them the flashing lights are random. And while rodents and birds quickly learn how to maximize their score, people often perform worse the longer they try to figure it out.
Humans often see what they think are long-term trends but base their analysis on short-term data.
A Wall Street Journal article Dec. 31, 2010, shows how this hurts most investors. It reported that CGM Focus fund was the top-performing mutual fund, by far, over the last ten years, generating an annualized return of more than 18 percent annually since Jan. 1, 2000, on a time-weighted basis. However, over the same 10-year period the average investor in this top-performing fund lost an average of 11 percent a year.
How is that possible?
It turns out the fund was so up and down during the decade that most investors were alternately panicked and selling out or optimistic and crowding back in.
The most dramatic example came after the fund was up 80 percent in 2007. Investors flocked in, putting $2.6 billion into the CGM portfolio – just in time to catch its equally dramatic 48 percent drop through the end of 2008.
Many credible studies show the average investor underperforms the market, some by as much as 6 percent per year, and this illustrates how it happens. Right after an investment generates strong returns, people tend to jump on the bandwagon. When an investment is struggling, people tend sell out and miss the recovery.
Ah, if we could only bring out the bird-brain in all of us.
Stan Johnson is the owner of Comprehensive Financial Planning in Durango. He began his financial planning firm seven years ago. He writes a quarterly financial newsletter, What You Need to Know, which is available on his website, compfinancial.com.