Silence fell as I realized that I didn’t have even a rough estimate of the P/E for Microsoft. I was ignorant of a key fact in spite of spending many hours a day reading financial papers. Furthermore, the P/E for any stock is readily available. With 1993 technology it would have taken me about five minutes to walk to my room and find the Microsoft P/E in the Wall Street Journal. With twenty-first century technology, such information is available instantaneously on the Internet.
Because I am a curious person, I didn’t just hide my head after my ignorance had been exposed. I started asking people about their investments. One person whom I spoke with (who was a financial professional) owned Apple computer stock, and he extolled the virtues of the easy-to-use operating system. I then asked him, not about the stock price (which he felt was low), but about the number of shares of stock that existed. His answer was, “Geez, I don’t know. It must be millions.”
The number of shares is equally as important as the stock price in figuring out the total value of the company. It is impossible to evaluate a stock if one is ignorant of the number of shares. In other words, this finance professional was as ignorant about his Apple computer investment as I had been in my Microsoft selection.
If you try this quizzing game with your friends, I suspect you will find that most of them don’t know much about at least some of their investments.
These sorts of financial blind spots are, at least in theory, easily corrected. The information is available, and I am in favor of everyone making sure that they have done a solid analysis before making decisions. The investing game is more subtle, however, than these stories suggest. The reason is that human behavior, including investment choices, is influenced to a surprisingly large extent by the lizard brain.
Many rational calculations are carried out in part of the brain’s prefrontal cortex, which is located above the eyes. When we think about our investments in analytic terms, the prefrontal cortex is the boss. Compared to other animals, humans have extremely large prefrontal cortexes, which explains our superior reasoning ability.12 While we are therefore uniquely able to make rational decisions, the lizard brain is also involved, and more involved than we suspect.
Psychiatry has long examined the different parts of the brain and how they interact. Sigmund Freud is most famously associated with his split-brain view of the world, consisting of ego, superego, and id. Freud’s view, of course, is built on a long tradition that dates back at least to Plato. Marvin Minsky is a modern scholar who postulates a brain filled with more than Freud’s three competing forces. His opinion of many mental entities is exemplified in the title of his book, Society of Mind.13
When I was in one of his courses at MIT, Professor Minsky told a funny story about his own brain. He said, “I was once scheduled to have breakfast with President Gerald Ford. Although I don’t normally miss appointments, I slept through this breakfast. I’ve never been prouder of my subconscious.”
Professor Minsky was making a number of important points. First, his prefrontal cortex was not in complete control of his behavior. Second, the subconscious often has goals that are different from, and perhaps in conflict with, the goals of the prefrontal cortex. Third, and finally, the subconscious is sometimes smarter than the prefrontal cortex.
My grandfather, who was known in our family by his nickname Mandy, gave me my first lessons in the power of my own subconscious. Mandy was a moderately famous psychiatrist who trained with Sigmund Freud himself and who maintained a friendship with Sigmund’s daughter Anna for many years. As a part of his training, Mandy was an accomplished hypnotist.
I was never hypnotized, but Mandy used the power of suggestion whenever I had the hiccups. He would say to me—in a particular manner that I have never been able to replicate—if you hiccup three more times, I’ll give you a quarter. In all the times that he did this to me, I was never able to produce more than one additional, pathetic hiccup. I’ve tried the trick on other people, and it does not work for me. Apparently, something in Mandy’s training allowed him to speak to my subconscious and alter my behavior.
During the Korean War, the Chinese used knowledge of the subconscious in their treatment of U.S. prisoners of war. The Chinese wanted the U.S. soldiers to collaborate with them and used a variety of extremely successful tactics ranging from brutal to cunning. In the excellent book Influence, Robert Cialdini describes these tactics in detail, including an incremental approach that I believe manipulated the subconscious. Almost no one was willing to collaborate fully and immediately, but over time people were pushed to more and more extreme behaviors. In the end, one in three American P.O.W.’s committed some serious form of collaboration, and some went so far as to abuse other Americans.14
For Americans who completely resisted, the Chinese would sometimes make a simple request. They would say, “We know that you are unwilling to make statements against the United States, but would you mind rewriting this statement by one of your colleagues? You do not have to put your name to the anti-American statement, nor tell anyone else of your actions.” The Chinese found that this simple step was an important one on the road to collaboration. After a prisoner had taken this act, he was much more likely to begin making his own statements against the United States.15 It seems that simply getting the brain to say or write something begins to change attitudes. A similar logic underlies Dale Carnegie’s suggestion to “get the other person saying, ‘yes, yes’ immediately.”
None of these examples prove that the subconscious is important. Perhaps Professor Marvin Minksy was simply lazy on the morning of his scheduled breakfast with President Ford. Similarly, we can’t know for sure why my grandfather was able to stop my hiccups or why saying or writing something changes our opinion. For proof of cause and effect we need to reenter the scientific world.
Studying with people who have some sort of impairment sometimes provides insight into the brain’s normal function. In our quest to understand split-brain influences, we can learn from people who literally have split brains. In most people the left and right sides of the brain talk to each other via the corpus callosum, which physically connects the two halves. Some people are born without a corpus callosum, and thus the left and right sides of their brains do not know what is going on in the other side. Studies of people with these split brains reveal that conscious parts of our brain are not always in charge. These investigations are described at length in a number of excellent books, including Professor Michael Gazziniga’s The Mind’s Past.16
To investigate brain function, scientists presented signs with written instructions to these patients with split brains. For example, the sign might have said, “Please wave now.” The patients would comply with these requests.
The interesting aspect of these split-brain studies came when the patients were asked to explain their actions. The scientists made sure that the signs were only seen in the left visual field where it would only register in the right half of the brain. They made sure that the left hemisphere of the brain, which controls speaking, did not see the requests. Because the brains of these patients were split, one half of the brain knew that the waving was a response to a request. The other half of the brain was completely ignorant of the cause, and this half had to explain the waving.
“Why are you waving?” Now the speaking part of the brain is faced with a dilemma. It has no information about the cause of the waving. Nevertheless, it can sense that the body did just wave. Rather than confess to its ignorance, the language part of the brain makes up a story. For example, it might say, “I thought I saw someone I knew.” Similarly, when half the brain is instructed to laugh, the ignorant half of the brain makes up an explanation like “I’m laughing because you are funny guys.”
These studies and others lead to a startling conclusion. We are built to cover up the fact that the lizard brain influences us. When we think we have decided to take an action with our rational brain, we often have simply made up a story for the cause of action. As with Professor Minsky, parts
of our brain outside the prefrontal cortex often set the course and leave the explaining to other parts.
Another interesting set of studies reveals the limits of our conscious brain. This phenomenon is known as the McGurk effect; if you search the web, you should be able to experience it yourself. The McGurk effect demonstrates that before sensations become consciously aware, they have been altered by the nonconscious brain systems. Here’s how it works.
When we listen to others speak, we use both our eyes and our ears. This is true even for those of us who have not been trained as lip-readers. In 1976, Harry McGurk and John MacDonald demonstrated this in the following manner. Professors McGurk and MacDonald tape-recorded a person producing the sound “Ba” and then combined that sound in a precise manner with a film of the same person saying “Ga.”17
What do you perceive when you hear the sound “Ba” while watching lips making the shape of “Ga”? The answer is a fused sound best described as “Da.” The most interesting aspect of the McGurk effect is that it never goes away. If you watch the video with your eyes closed, it is clear that the sound is “Ba”; opening your eyes produces “Da.” Even after watching the tape hundreds of times, and even knowing the true sound, the effect exists. We cannot use our rational brains to override the nonconscious preprocessing of the information.
The McGurk effect demonstrates that preconscious processing affects our fundamental perception of the world. Obviously, the prefrontal cortex cannot be in complete control if it has information that is altered and shaped by the other parts of the brain.
What have we learned so far? If we divide the brain into the prefrontal cortex and the lizard brain, we have seen that our prefrontal cortexes are often far from perfect. Next, we have seen that the lizard brain has a powerful influence on our behavior. We are built to make errors and fall into a variety of traps. Finally, we are built to create a cohesive story about our behavior, which makes it hard to understand the sources of our own actions.
The Lizard Brain Goes to Wall Street
“Democracy’s the worst form of government except for all the others,” said Winston Churchill. Similarly, rational investing, using our less-than-perfect analytic system is the worst way to make money except for the alternative of using our lizard brains. As we will see, the lizard brain pushes us toward destructive acts.
The only thing worse than having a flawed prefrontal cortex exerting weak control is not having the prefrontal cortex in charge. The most famous example of this comes from the sad tale of Mr. Phineas Gage. The incident happened on September 13, 1848, and the original newspaper article in the Free Soil Union tells the story.
Phineas P. Gage, a foreman on the railroad in Cavendish was engaged in tamping for a blast, the powder exploded, carrying an iron instrument through his head an inch and a fourth in circumference, and three feet and eight inches in length.
Amazingly, Gage recovered quite nicely from having this enormous metal bar pass through his brain. The bar weighed more than 13 pounds and was actually an inch and a half in diameter (larger than the circumference reported in the paper). Within less than a year of the accident, Gage felt strong enough to return to his railroad job. Furthermore, to a large extent his mental processes seemed intact.
His colleagues, however, soon found that Gage was not himself. He suffered from a number of new negative personality traits, and his coworkers concluded that he was “no longer Gage.” In particular, Gage lost the ability to execute plans that he made for the future. Even if his mental functions were unimpaired, the fact that his prefrontal cortex was no longer in charge prevented him from returning to his job as foreman and he subsequently left the employ of the railroad.18
The list of human foibles and weaknesses is a long one. We’ll now look at the most important demonstrations of individual irrationality that apply to investing. Readers who are interested in the topic more broadly are encouraged to read Richard Thaler’s The Winner’s Curse, or Nobel Laureate Daniel Kahneman’s Heuristics and Biases (edited by Kahneman as well as Thomas Gilovich and Dale Griffin).19
Irrationality #1: Pride Goeth before a Financial Loss
Paul Tudor Jones II is a legendary trader who has made hundreds of millions of dollars. Some of his exploits are covered in Market Wizards.20 My college roommate from the University of Michigan, Peter Borish, worked with Paul. Through Peter, I met the legendary trader and was able to spend some time with him.
You might think that great traders don’t suffer from the same biases as the rest of us. That may be true, but my impression is that they are more effective at limiting the damage caused by self-destructive aspects of human nature. When I visited him, Paul Tudor Jones had two handwritten signs over his desk. I interpreted them as messages designed to help his prefrontal cortex control his lizard brain.
One sign said, “Observe that the blade of grass that resists the lawn mower gets cut down, while the blade that bends remains uncut.”
In many areas of our lives, the right course requires us to swallow our pride, take a loss, and move on. If we are unwilling to bend, we, like the blade of grass, will suffer.
One of the most-studied areas in behavioral economics documents how people’s stubbornness costs them money. The setting is called the “ultimatum game,” and it is a very simple negotiation between two people. The game asks them to divide up a lump sum of money through a process that is decidedly unfair. One of the pair, called the Proposer, gets to suggest how the money should be divided. The second, called the Responder, is not allowed to counterpropose, but must accept or reject the ultimatum offer.
I played the ultimatum game in a workshop run by my advisor, Nobel Prize winner Professor Vernon Smith. In the version that I played, I won the right to have the proposal power by scoring well on a trivia question. I now had $100 and the right to set a take-it-or-leave-it offer to another workshop participant. Furthermore, the decision was made in an anonymous manner. Neither my counterpart nor I knew, or would ever learn, each other’s identity.
So I have $100. I can make an offer to my hidden counterpart that she or he can earn $10, $20, or any multiple of $10. If my offer is accepted, I keep my part of the $100 and my counterpart goes home with whatever cash I have offered. If my offer is rejected, we both earn $0. What to do? Let’s assume for a moment that one’s goal is to make as much money as possible. (That was my goal in the $100 ultimatum game.)
Here’s how I analyzed the game. The responder is in a tough situation. She or he can take whatever I offer or get $0. So even if I offer a small amount, the responder earns more money by taking my offer than by rejecting the offer. Based on this, I decided to offer $10 to my counterpart, while retaining $90 for myself.
Vernon Smith ran the workshop by having us first play the games for real money, then before we learned of our outcomes, we would study previous research on the topic. As I was thinking of how I would spend my $90 (I was confident that my offer would be accepted), we began learning of study after study where responders said “screw you” to low offers like mine.
Professor Werner Guth and colleagues performed the first ultimatum study, published in 1982. For stakes of 10 German D-marks (this was before the introduction of the euro), the players exhibited pride or a sense of fairness. In fact, 20% of responders rejected the offers. Furthermore, the average proposal was much nicer than mine. While I had offered a mere 10% of the financial pie, the first ultimatum game proposers offered an average of 30%.21
Since the original study, the basic findings have been replicated in literally hundreds of studies. In study after study, all around the world, people reveal themselves to be proud. They are willing to lose money to retain their self-esteem.22
Initially, many people claimed that the results couldn’t be true, and suggested the rejections were artificial because the monetary stakes were so low. Vernon Smith and his colleagues tested this supposition by having U.S. participants play the game for $100. They found no difference between play for $100 and pla
y for $10.23
The ultimatum game has been taken around the world, in order to test the role of culture and to increase the stakes even higher. In countries such as Indonesia, researchers have organized ultimatum games played for several months’ salary. Even with such high stakes, people are willing to walk away from unfair offers.24 And, in spite of cultural variation, Professor Guth’s original findings have also been found among nonindustrialized people who still hunt animals and gather plants for a living.25
Are ultimatum game rejections irrational? Not necessarily, but they definitely cost the participants money. Recall that these games are generally played just one time between anonymous counterparts who will never see each other again. A decision to reject an offer under such conditions means a loss of money that will never be recouped.
In many financial situations, we are faced with taking a small loss now or digging in our heels. The best course, especially if one wants to earn money, is to admit to small defeats and move on.
Mean Markets and Lizard Brains Page 4