In summary, U.S. housing prices seem to be in the early stages of unwinding what was a historic period of unsustainable increases. Not until the lizard brain hates housing is this market likely to become healthy again.
PART FOUR
Profiting from the New Science of Irrationality
This final section provides investment advice. In Chapter 10, we learn more about the origins of the lizard brain and why it costs us money. While our instincts may have helped our ancestors, we find that financial markets are the most unnatural setting for our brains. An understanding of the lizard brain provides a timeless blueprint for effective and low-stress investing.
In Chapter 11, we return to the central question of Mean Markets and Lizard Brains: “Where should I invest my money?” In Part One we found that we are built to have systematic problems in markets. In Part Two we looked at macroeconomic drivers of financial performance. In Part Three we examined the prospects for bonds, stocks, and real estate. Now in the final section we summarize all of the findings. We discover that the current situation is particularly dangerous—kryptonite for the lizard brain. And then finally we come to a surprising answer to the question of where to invest.
chapter ten
TIMELESS ADVICE How to Shackle the Lizard Brain
Timeless and Timely Tips
In The Graduate, a young Dustin Hoffman (playing the role of Benjamin Braddock) receives some succinct, and unsolicited, career advice from a friend of his parents, Mr. McGuire:
“I just want to say one word to you . . . just one word.”—McGuire
“Yes, sir.”—Ben
“Are you listening?”—McGuire
“Yes, sir. I am.”—Ben
“Plastics.”—McGuire
I don’t know if “plastics” was a good career choice in 1967 when The Graduate was released. I am sure, however, that there are better and worse times to work in particular fields. Similarly, the Mean Markets view is that there are good times and bad times to make particular investments. Gold, for example, was a great investment in the 1970s, and was a terrible investment in the 1980s and 1990s.
If markets were rational, then investing would be easy and stress-free. In the fairytale land of the efficient markets hypothesis, all investments are correctly priced at all times. Thus, in a hypothetical, rational investing world, it never pays to fret about possible mistakes; nor does it pay to seek bargains.
Out in the real world, however, markets are irrational and often mean. This creates both opportunity and risk. In a world where prices are often too low or too high, investors can find insanely good deals. We can also make insanely bad deals. Since the invisible hand has not built a world that is going to ensure our financial success, we have to do it ourselves.
Thus, the key to investing success—in the real world—is to be on the correct side of that irrationality. The Mean Markets and Lizard Brains advice for how to profit from manias and crashes is divided into two parts. First we’ll seek to prevent our own lizard brain from ruining us (this chapter). Then we’ll look for opportunities to make money from others’ lizard brains (next chapter).
This division of tips for investing in crazy markets is somewhat akin to preparing for a sports competition. To win, it is always good to be strong, fast, and experienced. The best strategy on any given day, however, also depends on the competition.
In the late 1980s, for example, the Detroit Pistons won consecutive NBA championships. In each championship year, they had to defeat Michael Jordan’s Chicago Bulls in the playoffs. To beat the Bulls, the Pistons relied upon excellent basketball skills (appropriate for any opponent), and they needed a specific strategy to contain Jordan. In this period of his career, Jordan was so dominant that opponents joked, “He can’t be stopped, just contained.”
To contain Jordan enough to win, the Pistons developed what became known as the “Jordan Rules.” These included myriad defensive schemes, frequent double-teams, and a tough approach that made Jordan pay physically for any attempted slam dunks.
The Pistons’ strategy was built on top of a talented roster that included Isiah Thomas, Joe Dumars, and Dennis Rodman. So the Pistons’ victories over the Bulls came from two complementary approaches. First, they had great players with solid fundamentals appropriate for any basketball game. Second, they used a specific, situation-driven strategy.
Similarly, investing success in a financial world that is often crazy combines an approach that is timeless with opportunism driven by the current situation. This chapter contains timeless suggestions for mean markets, and the next chapter provides timely advice for this era.
Why Our Toughest Financial Battles Are with Our Irrational Selves
“We have met the enemy, and he is us.” Walt Kelly coined this phrase in the comic strip Pogo on Earth Day 1971. Because people cause pollution, Kelly suggests that environmental progress must rely on modifying human behavior. Similarly, this chapter focuses on why we are so often our own worst financial enemies, and how to prevent this internal foe from bankrupting us.
In early chapters, we reviewed the evidence suggesting that mean markets stem from individuals who are far from rational. Furthermore, we found that the less-cognitive aspect of human mental abilities—the lizard brain—often causes our problems. To organize and utilize solutions to our financial shortcomings, it helps to understand why the lizard brain is built to bankrupt us.
Humans act irrationally in some financial situations because we are born without instincts that guide us to good solutions. In financial markets, we are fish out of water. The human financial situation is similar to that faced by other animals that live in unnatural, novel environments. It is something we share with our closest genetic relative, the chimpanzee.
Rational and Irrational Apes
Chimpanzees in the wild can demonstrate remarkable mental sophistication. I learned this directly in the summer of 1997, when I was living at a research station in the rainforest of western Uganda.
Harvard professor Richard Wrangham, who did some of his early work with Jane Goodall, founded the center in 1987. A central goal of the research was to follow and observe chimpanzees in their natural environment. When I arrived, the same group of chimpanzees (along with their offspring) had been observed and documented for 10 years.
In my stay with the chimpanzees, I grew to respect their intelligence. For example, one day I was following a group of wild chimpanzees when they entered an area of thick vegetation. My fellow human observers and I were unable to follow, and thus we lost contact with the animals.
Where could we find our chimpanzee group? My Ugandan companions suggested that we walk about two miles through the forest to a fig tree that was producing ripe fruit. Furthermore, the men suggested that we would arrive at the fig tree before the chimpanzees, and therefore we would be able to take a lunch break.
The Ugandans knew that the chimpanzees keep track of which trees are fruiting. Thus, the logical place to wait for them was at one of their tasty food sources. But how could we know when the chimpanzees would arrive? The answer is that the chimpanzees regulate their body temperature, and this provided an estimate for their arrival time.
When chimpanzees eat in these fig trees, they often climb high enough that they leave the shade of the forest floor and expose their dark and hairy coats to the sun. The chimpanzees don’t like to overheat, so on sunny days, the chimpanzees tended to visit this particular tree in the cool morning. On cloudy days, like the one in question, however, the chimpanzees tended to arrive later.
We marched off to the fruiting fig tree, ate our lunch, and had a nap. The chimpanzees arrived right on schedule! I found this amazing. To get to the right tree at the right time, the chimpanzees used a mental map of the forest, they understood the seasonality of the fruiting, they understood the weather, and they knew how to find their way. They did it perfectly!
So chimpanzees can be really, really smart. The Ugandan men were able to navigate their way through the forest o
nly because of years of experience. If I had been alone, I would have died in the forest long before I found any food (or chimpanzees). So these chimpanzees were able to solve this navigation problem better than most humans.
In contrast to savvy chimpanzees in the wild, those in zoos and research centers often look less intelligent. I learned this lesson in a humorous way from my friend Brian Hare, whom I met in Uganda that summer when he was a college student. He subsequently earned his doctorate from Harvard, and is now an accomplished primatologist.
Brian did some of his early work with chimpanzees at the Yerkes Primate Center in Atlanta. As an enthusiastic young scholar, Brian decided to see if he could get the chimpanzees to imitate him. Although one often hears the expression “monkey see, monkey do,” there is very little evidence that monkeys or apes (chimpanzees are apes, not monkeys) learn through imitation.
Brian’s test of chimpanzee imitation took the following form. Each day, he planned to do a headstand in front of the chimpanzees. Since chimpanzees do not normally perform headstands, any such behavior would be clear evidence of imitation. Brian explained his idea to the workers who cared for the animals. Their experience with captive chimpanzees had made them a bit cynical, and they laughed at Brian’s youthful zest.
Undaunted, Brian proceeded to do a headstand in front of the captive chimpanzees. What happened? Within a few moments, the chimpanzees did respond, not by doing headstands, but by throwing their dung at Brian. (Their aim was pretty good, and they seemed to especially enjoy hitting him in the face.) He quickly abandoned his headstand project.
Captive chimpanzees exhibit lots of strange behaviors that seem very different from the sophisticated rainforest navigation that I had observed in Uganda. In their artificial settings, captive chimpanzees have little to do (their food is provided), they do not travel long distances, and they even weigh much more than their wild counterparts.
In short, captive chimpanzees sit around, eat too much, exercise too little, and are so bored that they throw dung for entertainment. (Sound like your boss?)
Are chimpanzees supersmart, or are they overweight, lazy, and bored? The answer is that they are capable of both types of behavior; what they do depends on their environment. When chimpanzees are in their natural environment, their instincts guide them to appropriate behavior. In contrast, when chimpanzees are in certain types of unnatural environments, such as zoos and research centers, those same instincts get them in serious trouble.
Humans as Zoo Primates
Humans can be thought of as self-domesticated apes or as zoo primates. Our not too distant ancestors lived in small groups and earned their food the old-fashioned way—by hunting animals and gathering plants.
Technological change, first in the form of agriculture, and later in the industrial and information revolutions, has changed our world fundamentally. A modern city is as unnatural an environment for a human as a zoo is for a chimpanzee. (A big difference, of course, is that we have built and moved into our own zoos, while people placed other animals in zoos.)
In recent years, scholars have shown that some of our individual irrationality can be explained by understanding the differences between the human ancestral environment and the current world in which we live. Just as zoo chimpanzees do crazy things, so do “zoo” humans.
This idea of a “mismatch” between human nature and industrialized living conditions has been explored quite thoroughly in nonfinancial areas.1 Perhaps the problem shared by most people is that we enjoy the taste of foods that are bad for us. Why don’t we derive pleasure from healthful foods? The answer, according to some theorists, is that our ancestors lived in a world where both calories and dietary fat were scarce.
For our ancestors, this theory suggests, the more calories they ate, and particularly the more dietary fat they consumed, the better. Ancestral humans who ate more of what we would term “junk food” were better able to survive and reproduce than their competitors.
Thus, our ancestors were built to love food, and to especially enjoy fatty foods. The world has changed, and saturated fats, for example, now cause heart disease. Nevertheless, we are still built to feel joy at eating the foods that helped our ancestors, not the foods that would help us today. Professor William Irons of Northwestern University summarizes this hypothesis as follows in an important scientific paper:
In ancestral environments, these preferences [towards different foods] motivated people to come as close as their circumstances allowed to optimal diets. However, in modern environments, the abundance of different types of foods is vastly different, and these preferences often motivate people to choose diets that are much less healthy than are possible in their [current] circumstances.2
Because we live in a different world from our ancestors, our very human nature pushes us toward food that is bad for us. In a famous scientific article, “The Past Explains the Present: Emotional Adaptations and the Structure of Ancestral Environments,” Professors John Tooby and Leda Cosmides make the same argument about human logical abilities.3 What was good for our ancestors can be bad for us living in a modern world.
Professors Cosmides and Tooby reason that it is simplistic—or downright wrong—to say people are irrational. Rather, our behavior depends on the context. In settings that were relevant to our ancestors, we are able to perform brilliantly. In novel settings, however, even with our big prefrontal cortexes, we look silly because we are fish out of water.
Using this logic, Professor Gerd Gigerenzer and colleagues are able to rephrase the Linda-the-bank-teller question that tripped us up at the beginning of this book in such a way that people behave rationally. Recall from Chapter 2 on individual irrationality that most people commit the “conjunction fallacy” by choosing answer (2) in the following problem instead of the correct answer (1).
Linda is 31 years old, single, outspoken, and very bright. She majored in philosophy. As a student she was deeply concerned with issues of discrimination and social justice, and also participated in antinuclear demonstrations.
Which of the following two alternatives is more probable?1. Linda is a bank teller.
2. Linda is a bank teller and is active in the feminist movement.
Professor Gigerenzer changes the problem slightly to:
Linda is 31 years old, single, outspoken, and very bright. She majored in philosophy. As a student she was deeply concerned with issues of discrimination and social justice, and also participated in antinuclear demonstrations. (This part is identical to the other wording.)
There are 100 people who fit the description above. How many of them are:
Bank tellers?
Bank tellers and active in the feminist movement?
In this second version, the conjunction fallacy disappears as most people get the question right.4 In a series of related experiments, Professor Gigerenzer has shown that human brains work better when problems are described in frequencies (e.g., how many out of 100?) as opposed to probabilities (e.g., which is more probable?). Professor Gigerenzer argues that human brains are built to deal with frequencies.5
Why are humans better at frequencies than probabilities? No one knows for sure, but I always imagine humans in the ancestral environment thinking about outcomes in terms of frequencies. Something like, “Remember when it last rained like this, we caught those tasty antelopes on the west side of camp.” I never picture them saying, “The probability of successful hunting increases by 7% during rains.”
The conclusion of the work by Professors Cosmides, Tooby, Gigerenzer, and others is to reconsider how we should interpret human acts that appear to be irrational. This more nuanced perspective suggests that humans are not designed to be crazy, but rather that we can be pushed to crazy actions by certain situations.
There is an active debate within academia on the value of this ancestral perspective. Interestingly, many of the leading behavioral economists, including Professor Richard Thaler, see little value in considering how human nature was shaped in ancest
ral environments.6 Others (including me) see the ancestral perspective as a primary organizing principle underlying all study of human nature, including its irrational aspects.
This idea that human problems stem from living in an unnatural environment helps to understand the deep cause of human irrationality, and it provides the basis for the practical advice in the rest of this book. The key hypothesis is that many of our financial difficulties stem from the fact that, like captive chimpanzees, humans are built for one world yet live in another. So humans are not built to make good financial decisions.
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