Rational Investing and Tricks the Mind Plays

by Jane Bryant Quinn -Bloomberg

How good an investor are you? If you’re like the average Joe or Jane, you think — for sure — you’re better than most. You remember every one of your winners, in detail. You bury your losers. You never average the two together, which means you have no idea whether you’re beating the market or not. If asked how you’re doing, however, you’ll probably say that you’re ahead.

This confident approach to investing does wonders for your self-esteem. Where it leaves your portfolio is another story. We all know we’re not supposed to trust our emotions when we buy a stock. What we didn’t know is that our investing brain is a traitor, too.

We’re hard-wired to kid ourselves. If you doubt it, take a look at “Your Money and Your Brain,” a new book by Money magazine writer Jason Zweig. He visited the scientists who study the neural circuits that switch on and off when we invest. It turns out that our brains amount to a hostile environment. To be better investors, we have to work against what our minds want most to do.

Take one of our sturdiest investment beliefs: that with study, we can get good at predicting whether a stock or the general market will rise or fall. To do this, we search for patterns that can tell us what the future holds.

The human brain loves patterns. We see them even where they don’t exist. Give us random facts and we’ll assemble them into a story. Give us random data — like the millions of stock quotes flying around — and we’ll arrange them to “make sense,” whether they do or not.

Seeing Patterns

You can see this tendency at work in a series of studies done at Dartmouth College. Researchers flashed red or green lights on a screen. The participants had to predict which color would come next. Eighty percent of the flashes were green but the order was random. Over time, the participants learned that green was the most likely call.

Rats and pigeons, fed when they made the right guess, quickly learned to pick green almost all the time.

That’s not what human subjects do. We — the brainiest mammal — start trying to guess when the next red flash will come. We look for patterns, even when told that the flashes are random. The longer we play the game, the worse we do. Rats outscore us every time. Various iterations of this study have been done since the late 1960s, always with the same results.

Then there’s dopamine, the brain chemical that spurs us to act when we sense the possibility of a reward. An unexpected gain — say, a chat-board tech stock doubling in three months — sprays dopamine over every available surface. If it happens twice, we’re sure the chat board is in the know.

Getting Hooked

Zweig calls this our “prediction addiction.” We’re addicts for sure. The brain activity in a cocaine user expecting a hit looks almost the same as that of an investor expecting a big score.

The startling thing about pattern seeking is that your brain makes you do it. You can’t say no. The response is subconscious and automatic. Because you’re unaware of what’s going on, the patterns you see seem objectively true rather than neurally driven. Your dopamine turns you into a dope.

We find patterns fast. Two accurate calls will make you expect — and bet on — a third. Three is a “trend.” Studies show that people seeking new money managers tend to hire a firm after a three-year hot streak and fire one after a three-year cold streak (even though both of these streaks are probably about to change).

Seersucker Investing

The seersucker theory of investing says that, for every seer, there’s a sucker. David Leinweber, an expert in quantitative investment, satirized the “science” of prediction by sifting through numbers to see how he could have forecast the performance of the U.S. stock market from 1981 through 1993. He combined the total volume of butter produced each year in Bangladesh with the number of sheep in the U.S. and a few other variables, to produce a formula that forecast the past with 99 percent accuracy.

Wall Street is afloat in back-tested formulas meant to forecast prices. The next time you see one, think baaaaa.

You can’t quit predicting, but you can quit following your mischievous brain. Handcuff yourself to some form of automatic “program” investing. Buy-and-hold. Dollar-cost averaging. Fixed asset allocations (say, 70 percent stocks, 30 percent bonds), rebalancing when your portfolio drifts away from those levels.

Quit checking your stocks all the time. Those random squiggles will start looking like patterns before you can tear yourself away.

Finally, make an effort to find out how well you actually perform. For example, keep track of your stocks on Bloomberg.com’s Portfolio Tracker. Average the winners and losers together to see how you’ve done each year.

While you’re at it, keep track of the stocks you sold (something investors rarely do). If the ones you sold do better than the ones you bought, maybe your dopamine is still in charge.

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