Illusory Patterns

Some people's investment results would improve from targeted brain damage.

This rather shocking statement is based on an article Jason Zweig wrote in the Wall Street Journal, "Why We're Driven to Trade." Neuroscience research has shown that specific parts of the brain contribute to certain decision making. More narrowly, researchers have found that one part of the brain, the frontopolar cortex, contributes to predicting rewards.

To better understand such decision making, researchers set up an experiment with three groups: two groups without brain damage and one group with damage to their frontopolar cortex. Then, they let the three groups play a series of games where the rewards varied unpredictably. 

What they found was that the two groups without brain damage tended to base their decisions on very recent data--their last two games played--whereas the group with brain damage tended to base their decisions on cumulative data of all the games they'd played. The more effective approach is to use cumulative instead of recent data.

Basically, the frontopolar cortex is a part of the brain that's used to recognize patterns. It works great when there are useful patterns to be recognized, but when no patterns exist (as they don't with random data) it goes right on recognizing illusory patterns that aren't really there. 

The result is that when we run into rewards with unpredictable variability, our brains still tend to react as if it finding patterns (even though there are none). That's why people with a damaged frontopolar cortex have an advantage in dealing with such circumstances: they don't have a part of the brain that would recognize and act on illusory patterns.

This research holds lessons for investors, because investment returns--and you may have guessed this--vary unpredictably just like the game in the experiment. Like the two groups without brain damage, most people base their investing decisions on recent instead of cumulative results. This leads them to trade too frequently, selling something that has done poorly recently and buying something that has done well recently only to find what they bought does poorly and what they sold does well.

The good news is that you don't need to damage your brain to invest better. Investors who base their decisions on long term, cumulative results instead of recent data can do just as well as those with a damaged frontopolar cortex. 

First, don't buy just because a stock goes up or sell because a stock goes down. That's basing your decision on recent data. Second, use long term, cumulative data to make decisions instead of short term, recent data. Third, make sure you have three reasons, outside of stock price movements, for deciding to buy or sell. And, last, keep track of your results so you can generate a cumulative record of what does and doesn't work. This is best done by keeping track of what you sell as well as what you buy.

You don't need brain damage to do better, you just need to create a deliberate decision making process that does an end-run around the part of your brain that sees illusory patterns. 

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

The myth of the rational investor

One aspect of my job I love best is reading to broaden my horizons. I recently finished a book by Dan Arielly called Predictably Irrational: The Hidden Forces That Shape Our Decisions. It was an eye-opening look into how real humans make decisions and what traps to avoid.

This may sound like heady stuff, but it's quite useful to a professional investor like me. You see, I happen to be human, and knowing the errors that humans frequently make can help me avoid mistakes and become a more successful investor over time. Quite practical, really.

Arielly highlights that most economic theory, up until the pioneering research done by behavioral economists, tended to assume that humans make fully rational decisions, especially when it comes to spending money. On the contrary, research has shown that we humans make all kinds of silly mistakes.

For example, we tend to over-value what we own. Before we buy a car, say a VW bug, we want to pay as little as possible for it. But, once we've bought it, we suddenly value it much more than we did before ownership. We won't sell it unless we can get top-dollar, even though we didn't think it was worth top-dollar when we bought it. And, the longer we own it, the more attached we can become, especially if we put a lot of work into ownership. I'll think about that the next time I go to sell a stock. I may want a price no one's willing to pay simply because once I've owned it for a while. Using objective value measures like price to earnings or price to book value give me an objective reference point to avoid this trap.

Another problem for humans is we want to keep our options open. Keeping options open makes sense in many contexts, but not when economic costs outweigh benefits. Arielly and crew showed how people generally over-weigh the benefit of keeping options open, literally to the degree of putting a higher price on keeping options open than the benefit derived. By trying to keep our options open, we frequently get distracted from the true objective. I'll remember this the next time I go to make an investment decision. When considering investment options, I know that wanting to keep my options open may distract me from making a good decision. Instead, I'll make the best decision given the facts and move on.

We humans are also greatly impacted by our expectations, and we may never change our minds even when confronted with contrary evidence. Arielly and his colleagues demonstrated through several experiments how people's pre-conceived notions literally impact their experiences. This is easy to find with investing, too. Once we buy an investment with the vision of great wealth pouring down on us, we hold on to that vision long after the facts have shown the vision to be faulty. This is a great thing to keep in mind when making investment decisions. Am I ignoring evidence? Am I looking for opinions different than my own? Can I dig for dis-confirming evidence instead of just looking for proof that backs my pre-conceived notion?

Being human has many wonderful benefits, but being rational decision makers, in the economic sense, is not one of them. This doesn't mean we should throw in the towel, it just means we have to be very objective when making investment decisions. This book helps me ask myself: 1) am I over-valuing something simply because I own it? 2) am I losing economic benefits because I want to keep options open? 3) am I looking for dis-confirming evidence to contradict my pre-conceived notions? Such questions lead to better decision making and better investment results.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.