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Monday, 14 December 2009

Stocks Aren’t Snakes

Rational or Emotional?

How do humans make decisions? Are we careful, rational processors of information or emotional, rapid – but possibly illogical – decision makers?

Well, the easy answer is that we’re both. Sometimes we take our time over decisions and sometimes we don’t. Some of us make more decisions one way rather than the other but we all use both methods some of the time. The question is, why do we do this? Why have two decision making processes, the results of which must inevitably lead to different outcomes on occasion? To answer this let's don our outdoor gear and go for a ramble in the wild.

Jungle Thinking

We’re strolling through the jungle, trying to avoid tripping over poorly camouflaged wildlife camera crews and assorted Z-list celebrities, when a sideways glance notices something that looks suspiciously sinuous and definitely snake like. You may have only moments to live. What do you do? C'mon, think!

Well, almost certainly thinking is the last thing you do. Research suggests that your optical nerves flash information to the amygdala in the deep, old reptilian part of the brain and in response you react just about as quickly as it’s possible for the human body to react, given the time it takes electrical and chemical information to flow, something less than 300 milliseconds. With good reason, for your very life may hang in the balance.

Sadistic Researchers

As the above research indicates it’s the old part of the brain that does the processing. This has been demonstrated by sticking people in brain imaging systems and then torturing them by showing them pictures of various creatures they may have phobias about: snakes, spiders and day-time talk-show hosts being especial favourites. The psychologists that perform these types of test aren’t noticeably more sadistic than the rest of the population; they’re just interested in figuring out which bits of the brain process different sorts of information.

These ancient, deep brain functions can produce the kind of speedy reactions needed to have a chance of escaping certain, hissing death because they require no conscious processing. However, this rapid response comes at a cost – we’re quite likely to mistake sticks, shadows and virtually any vaguely slender, long thing as a snake. In adaptive terms this isn’t too bad – misidentifying bits of forest furniture a dozen times doesn’t matter much as long as we get it right the one time it does: this type of unconscious, automated processing costs us very little in energy terms.

Modern Thinking

Exchanging one jungle for another we find ourselves uncomfortably seated, in a chair that seems to have significantly shrunk since we last used it, at the front of the class while being harrangued by a harridan disguised as a teacher. "What's 32 * 7?" she demands as the rest of the class snickers. C'mon, think!

Well now we actually do think. Placed once more in the brain scanner we can see that it’s the new, frontal part of the brain that starts to grind away to produce the answer. Grind is what it does, as it engages in deep and detailed processing. The last time we thought this hard was when we tried to calculate our tax return.

These newer parts of the brain are adapted to the social world we live in, engaging in culturally mediated tasks that require the higher functions of our neural circuitry. Such processing generally doesn’t need to be particularly fast and that’s fortunate because this type of thinking consumes the body’s energy resources as the brain churns away to come up with the answer. This is the type of processing that we only want to do if we really need to, because in an environment where food is scarce, using these areas of the brain more than we absolutely need to is not sensible. That’s why math seems hard for most of us – because it is.

Reptile Brain, Ape Brain

It’s possible to characterise these different parts of the brain in these different ways. The old reptilian part – the limbic system – manages automated stuff – like breathing – and handles processes which require fast reactions but have a fairly high rate of error, albeit with low energy costs. The new ape part – the prefrontal cortex – handles things that require intensive processing, costing lots of energy but generally only engaged in through conscious effort – supposedly meaning that we’ll only do them if we really need to. There would seem to be sound evolutionary reasons for not thinking any harder than necessary, assuming we developed in a world in which food was a scarce resource.

This type of dual model of the brain is hardly revolutionary, pre-dating even the "I think therefore I am" dualism of René Descartes, but has been brought comprehensively up-to-date by the discoveries of neuroscience. There's lots of work in this vein around - see Animal Spirits: Affective and Deliberative Processes in Economic Behaviour by George Loewenstein and Ted O'Donoghue for a good example.

So we consider the question, consciously, and eventually arrive at the answer by dint of sticking our tongue out and taking off our socks to use our toes as well as our fingers. We're dismissed ignomoniously from school and end up doing what most people do if they're rubbish at math: yep, we become a stockmarket trader. Now we’re presented with the annual results of a well known company, hot off the press, and with only moments before the market opens. Buy or sell? C'mon, think!

Excited and Wrong

Once more our neural pathways flash into operation – but which decision making process gets engaged: the old, error prone emotional ones or the new, energy intensive conscious analytic ones? Somehow our neural processes have to decide which type of process to engage in and this decision must be unconscious. Somehow we need to make a rapid judgement about whether we need to react to a snake or whether we can take our time and think.

The trigger for this choice is emotion – when we’re excited the brain tends to fall back on the more automated, emotion driven processes. Often stock investment is done under time pressure and in an emotional environment which kickstarts the old, rapid emotional decision making processes. Only stocks aren’t snakes and while we have carefully adapted automated processes for dealing with the situation where we encounter a hissing coil of death we have no such mechanisms for handling investment decisions. So if we tend to use the emotion driven, error prone ancient processing of the rear brain to deal with stocks, rather than the consciously considered but energy intensive – and therefore downright hard – processing of the fore brain we will see all sorts of strange results.

Time is Not Of The Essence

This, of course, would explain how come some people consistently make dumb investing decisions but it isn’t quite enough to explain why they actually behave this way. Some of us, obviously, are driven by our emotions more than others and may get ourselves overly excited by some go-go stock that we’ve just spotted. However, what seems likely is that we're getting ourselves emotionally confused by the concept of time.

When faced by our potentially deadly snake time is absolutely critical. Engaging our rapid reaction processes is essential and the brain’s complex mix of chemical and electrical processing is engaged to this end. Unfortunately if we get ourselves excited and then convince ourselves that time is of the essence we can also induce the same reactions in less critical situations.

The problem for anyone trying to trade in these kinds of tight timescales is that the brain doesn’t have a good way of making error-proof decisions. You can’t engage the right bits of neural processing at that speed and so mistakes – lots of mistakes – are inevitable. The alternative, slower but harder, conscious decision making processes are obviously the better ones to use for investing.

And, Breathe ...

This, of course, is just another piece of a behavioural jigsaw that points to the types of errors we’re inclined to make, one that can be loosely described as the new science of neuroeconomics. Generally putting ourselves under time pressure to make investing decisions is bound to result in a high number of errors because it means, by definition, that the only thing we’re not doing is thinking. In fact using ancient, automated processes to handle modern, difficult decision making is probably one of the common factors underpinning many of the irrational behaviours of investors.

To be positive, however, these are errors we can learn to overcome. It isn’t that hard to learn that investing decisions shouldn’t be made in a hurry. Of course, this means that occasionally we’ll miss that exceptionally hot stock available for a bargain price for a few moments but mainly it’ll lead to us not investing in a bunch of dog-eared dead-ends that cause us nothing but losses. In stocks it’s avoiding the big mistakes that usually matters most.

Your Money and Your Brain: How the New Science of Neuroeconomics Can Help Make You RichThe Feeling of What Happens: Body and Emotion in the Making of ConsciousnessThe Tell-Tale Brain: A Neuroscientist's Quest for What Makes Us Human

Related Articles: Ambiguity Aversion: Investing Under Conditions of Uncertainty, Get An Emotional Margin of Safety, What's Your Financial IQ?

3 comments:

  1. I believe that the key is having confidence in your decisions. The market does a lot to shake you up. If you have inner confidence, you can weather the storm, If not, you cannot.

    I don't believe that it is possible for an investor following a Buy-and-Hold strategy to develop inner confidence (many Buy-and-Holders evidence bravado, but that is not at all the same thing). The problem is the core assumption of Buy-and-Hold that price does not matter (if price mattered, you obviously would go with different stock allocations at different prices). We all buy thousands of products and services and learn from those purchases that price always matters. So this "idea" that when buying stocks price does not matter just doesn't stick.

    Rob

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  2. I mountain bike, and see lots of snakes and snake-like roots. The amazing thing is how seeing a real snake turns on the snake-detector. Then every root is a snake for a day or two.

    On this relative to risks, I always thought it was funny that I'd ride alone in mountain lion territory, while maintaining a bond and CD heavy portfolio. I'd rather be eaten than poor?

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