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| Teach Yourself to Become a Better Investor |
| by
Christine Benz
| 10-15-09 |
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The field of behavioral finance examines the intersection between psychology and economic decision-making. In his fascinating recent book, Your Money and Your Brain, Wall Street Journal columnist Jason Zweig examines a heretofore little-known aspect of behavioral finance: neuroeconomics, or how our brains respond in real-life financial situations. I recently sat down with Jason to discuss investor behavior, the 2008 market crash, and his tips for becoming a better investor. This interview originally appeared in the Morningstar PracticalFinance newsletter.
Christine Benz: People may be familiar with behavioral finance. How is neuroeconomics different?
Jason Zweig: What neuroeconomics does is take the high-technology tools of contemporary neuroscience, which center on the ability to observe activation in the brain at the regional level. So you're able to see which areas of the brain are activated under particular circumstances, and then you correlate that activity to behavior and also to the stimulus that triggered the activity in the first place.
So for example, if our objective is to learn something about the brain processes that determine risk-seeking behavior, we might present somebody with the option to make a small amount of money or to lose a large amount of money, and see what's happening at the level of neurons in that person's brain. The best-established finding is the evidence that Kahneman and Tversky presented roughly 30 years ago, that people feel the intensity of a loss about twice as strongly as they feel the pleasure of an equivalent gain. So losing $100 hurts 2 to 2 1/2 times more than winning $100 feels good. The neuroeconomic experiments tend to confirm that because they show that losing money activates parts of the brain that are associated with physical pain or disgust, like smelling vomit or stepping in dog doo. So that's the first level that confirms it.
Benz: You went through some of this testing to examine your own brain's response to financial performance--in relation to some of these stimuli. What were some of the interesting things you found out about yourself?
Zweig: The first thing I learned wasn't particularly surprising to me, and certainly was no surprise to my wife, which is that I perform no better than anybody else, and in some cases worse, on the kinds of tasks that you might be presented with in one of these experiments. I think the only unusual thing about me is that I've been shown in at least one experiment to have an unusual degree of patience. I'm willing to wait considerably longer than the typical person to get a reward.
Benz: And that's an advantage in investing.
Zweig: It is, but what's interesting about that is that that's not exactly what my brain scan showed. It's what a behavioral test showed. So it appears that through many years of training and discipline, and studying Benjamin Graham's work, and simply observing the markets and learning about financial history, I seem to have trained myself to become more patient than my genetic and biological makeup would suggest I naturally am..
The biggest and most surprising lesson to me came in an experiment that I did at Emory University. It was an example of what Gregory Berns, the neuroscientist who did the experiment, calls "learning without awareness." It turns out there are very powerful functions in the brain that enable us to recognize patterns without ever becoming aware we've been exposed to them. This pattern-seeking behavior in the human mind is just an incredibly powerful function. Most of us don't realize how automatic it is, and at what an involuntary level it occurs. So a lot of the trading behavior and what we might call "Cramer-like" behavior, where people see something happen two or three times in a row and just assume it's going to happen again, that sort of thing goes on in your brain whether you want it to or not. And it can drive your behavior even when you're trying to resist it unless you have formal decision structures in place to prevent yourself from acting on it.
In these particular experiments I was being asked to engage in a probability guessing experiment that required a lot of conscious thought, much like playing a game of checkers or backgammon. Simultaneously, I was being presented with a much more basic stimulus, which was that I was getting little sips of sugar water. And there was a pattern to the sips of sugar water that my conscious brain paid no attention to because I was trying to solve the more complicated problem. But the unconscious part of my brain soon detected what was happening with the sugar water. And the next thing I knew, I was pressing madly with my right index finger to indicate that I had solved the problem, even though I had no idea how I had done it. And it was simply that the pattern of sugar water had started to repeat and that part of my brain recognized this repetition, while the conscious part of my brain was still searching for a solution. That sort of thing goes on all the time in the financial markets. And individual investors do it, and financial advisors too do it, without realizing it. And that's why we need formal decision rules.
There's been a real cult in the past few years of intuition and gut feeling and hunches. It kind of started with Malcolm Gladwell's book "Blink," and now there's a whole cottage industry devoted to helping people tap their inner dartboard. At least when it comes to financial decision-making, it's hard to imagine a worse way to go about things. It's not that you should never listen to your gut or that your intuition is always unreliable. It's that intuitions are a good guide only under very specific instances, and it's primarily dependent on the nature of feedback. Think of a professional tennis player, for example. Every decision is consequential. If you make a mistake, you fall behind in the game because your competition is intensely competitive, millions of dollars may hang on the result, and the feedback is instantaneous. If there's a hitch in your swing, the ball goes the wrong way and you know it went the wrong way.
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