Neuroeconomics and Investment Insanity

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by: Roger Dooley

The human brain didn’t evolve to pick stocks, which explains why there are so few Warren Buffets among the ranks of fund managers. Jason Zweig, author of Your Money & Your Brain (reviewed in Ignore Your Brain and Get Rich), did a lengthy interview with the Journal of Indexes. The publication, which seems to be geared to promoting index funds (funds that invest in large baskets of stocks without active stock-picking by fund managers), could hardly have chosen a better subject to interview.

In his very readable book on neuroeconomics, Zweig points out the many foibles of the human brain, and how a brain that evolved to help humans survive in the forest or on the savannah is particularly poorly suited to decide, say, whether it would be better to buy shares in Google or General Motors today. Pattern recognition ability is useful in learning to avoid, say, unpleasant-tasting plants or stinging insects, but may lead an investor to conclude that a stock that has performed well in the recent past will likely continue to do so in the future. In the interview, Zweig notes,

When you make a decision about risk and losing money, that’s handled by the same kind of circuitry that responds when you face physical risk and mortal danger. There’s not much difference in the brain between having a rattlesnake slither across your living room carpet and having some stock you own go down 40 or 50 percent. Basically it’s the same response, which is, ‘’I’m in trouble; how do I get out of here alive?’’ It’s incredibly rapid.

Zweig proves to be the index fund poster-boy: he admits that he neither picks stocks himself (his portfolio contains no individual company shares) nor trusts even the most expert of fund managers (he owns no actively managed funds). He invests only in index funds, which hold broad groups of stocks (such as those in the S&P 500) and are managed by compter algorithms which maintain balanced representation of each company. Index funds don’t need to employ high-priced management teams, and have low annual costs. In the long run, many believe, the savings from low management fees result in a better return than illusory gains from stock-picking acumen.

While Zweig writes about neuroeconomics, those interested in neuromarketing will find his many examples of unconscious (and perhaps irrational) behavior illuminating. He makes a key point that is equally applicable to neuromarketing:

The really surprising thing is how little we know about how we think. J.P. Morgan once said that every man has two reasons for everything he does: the reason he states and the real reason. I think he meant something a little different by it, but what a neuropsychologist or a neuroeconomist would say is that most of us don’t even know why we do things, and we can often be in the grip of unconscious emotion or unconscious biases, feelings and inclinations that are in our mind but we have no awareness of. You feel it; you just can’t articulate it, and you may not be aware that it’s there until after it passes. This is one of the hardest ideas you can ever get someone to admit.

Whether we are buying shares in Microsoft, a bottle of perfume, or a new car, that same insight holds true.
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