The lizard brain helped our ancestors achieve their goals, but in situations that were never experienced by our ancestors it often pushes us toward self-destructive or seemingly irrational acts. When it comes to financial decisions, the situation is far worse than a lack of natural talent. There are three sorts of decisions that we face. For some decisions the lizard brain’s effects are neutral, for others the lizard brain guides us toward the correct solution, and for the third category the lizard brain is systematically out of sync. Financial markets are this third and worst of these settings.
Neutral Setting: The Lizard Brain Looks Silly in Las Vegas
In the 1980s, I lived in San Diego and took periodic road trips to Las Vegas with my buddy Jim. During one of those trips, I found him sitting at the roulette table using an “interesting” betting strategy. When the roulette ball landed on red he would place a bet on black for the next spin. Conversely, whenever the ball landed on black he would place his next bet on red. I asked Jim to explain his strategy, and he said, “Dude, isn’t it unlikely that the ball will land on the same color twice in a row?”
Jim’s analysis was not correct. As long as the roulette wheel is fair, it doesn’t remember the previous spin. Thus, the bet on red has the same chance on every spin, even if, for example, it follows a streak of 10 red in a row.
Jim’s logic reminds me of the misguided traveler who takes a bomb on a plane, not to blow it up, but rather for protection. When asked how a bomb (that he doesn’t plan to explode) provides protection, the traveler responds with, “Dude, isn’t it unlikely that there will be two bombs on the same plane?”
Although Jim’s logic was not perfect, his betting strategy was fine. In fact, his alternating strategy has exactly the same probability of winning as other strategies, including bet red every time, or bet black every time, or even to bet black on sunny days. Any strategy that wagers on red or black has the same expected payoff.
In Full Metal Jacket, the Marine drill instructor says that he does not look down on anyone in particular. Rather than target some types of recruits for his abuse, he says, “Here, you are all equally worthless.” Similarly, all betting strategies on the roulette wheel are equally worthless—they all cost the gambler money, and earn profits for the casino.
Recall that our lizard brain is built to find patterns, even when there are none. There is a study showing physiological surprise (as measured by electrical activity) when a pattern is broken. For example, when flipping coins, the more heads that occur the less surprised we are by another occurrence of heads. Even though the prefrontal cortex knows that the chance of heads is 50%, part of the brain uses the past to predict the future.7 So if we sit and watch a roulette wheel long enough, our lizard brain will find a pattern, even if our prefrontal cortex knows that any pattern must be the result of randomness.
Fortunately, the roulette wheel is neutral with regard to the use of any strategy built on faulty pattern seeking. So in one sense our irrational pattern-seeking brain is harmless in memoryless settings like roulette. (Of course, the very fact that people enjoy betting on gambles that lose more often than they win is a costly exploitation of our lizard brains.)
Helpful Setting: The Lizard Brain Finds Food in the Kalahari Desert
Although our instincts seem silly in casinos, in other settings they help people make good decisions. In fact, many aspects of our brains, including the parts that see patterns when there are none, arose to help our ancestors.
Because our modern world is unnatural in so many ways, some of the best examples of instinctual problem solving come from the behavior of people living like our ancestors did, in small groups of foragers. Many of these foraging cultures, where people survive by hunting animals and gathering plants, existed just a few decades ago. Most such societies have disappeared (or been destroyed), but we have anthropological records of their foraging lifestyles.8
Until recently, for example, the !Kung San lived in the Kalahari Desert by gathering plants and hunting animals much as their ancestors had for 10,000 years or more. (The “!” is a “click” used in a few places around the world including the Khoisan language of these people, and !Kung San means “real people.”)
In separate anthropological studies, Professor Richard Lee and Professor Irven DeVore lived among The !Kung San of the 1960s. They each report that these people were excellent at living in a very harsh environment.
Professor Lee writes that the !Kung San “are such superb trackers and make such accurate deduction from the faintest marks in the sand that at first their skill seems uncanny . . . Perhaps the most amazing skill is in the hunter’s ability to figure out the number of minutes or hours elapsed since the animal went through.”9
The ability to find and use patterns was a key survival skill of the !Kung San in the harsh desert. The !Kung San can read something extremely subtle in an animal’s track, for example, and that allows them to obtain meat. Finding an animal thus relies precisely on the ability to find patterns in an uncertain world.
In natural settings our pattern-seeking brains can work beautifully. Unlike the casino, in the natural world it is usually good to look for patterns.
Until the invention of agriculture about 10,000 years ago, all humans foraged for a living. There is evidence that our brains today still reflect those ancestral foraging problems.10 This suggestion comes from a variety of studies including some showing that men and women have different abilities that may have helped our ancestors find food.
In almost all foraging societies, there is a division of labor where women gather plants and men hunt animals. Without baby formula and plastic bottles, women must travel with infants so they can breast-feed. Thus, even if an ancestral society were equalitarian, it would be harder for women to hunt than for men. Thus, the need for women to feed babies directly through lactation pushed men and women toward different lifestyles, even in societies that were not sexist.
Among our foraging ancestors, men and women had different roles. In particular, the plant food that women sought did not move, while the animal food that men sought tended to move around a lot. This sexual division of labor caused researchers Irwin Silverman and Marion Eals to predict that woman would be better at remembering the location of objects.11 Plants don’t move, so it pays to remember where they are located. This type of memory is not very useful for hunting animals.
Experimentally, Silverman and Eals showed that women are significantly better at what they call “object location memory” tasks. This difference is so profound that it is easy to replicate even in small groups, and I like to test my students in class. After they have provided their answers, but before revealing their scores, I show my students the data from studies around the world. Out of a perfect score of 20, men average about 12 on this test, and women average about 14.
When running this task in my classes, I always disclose the men’s score first. Harvard men are so good that they are even better than the average woman from around the world. So I get average male scores in the range of 16, which leads the Harvard men to think they will defeat the Harvard women. This is just a setup as Harvard women score almost perfect 20s and have always soundly defeated the men in my classes.
If Silverman and Eals are right, as this task suggests, not only are people built to solve ancestral problems, we are even adapted to solve certain types of problems. (A humorous strand of the research related to Silverman and Eals’s work looks at differences in the way that men and women give directions. As far as I know, there is no scientific reason for the fact that men never ask for directions.)
So our natural instincts look pretty good in our natural environment. It’s almost as though we were designed to be hunters and gatherers. As Richard Lee said of the !Kung San, we are almost “uncanny” in our abilities. We have brains that worked well to solve ancestral problems. Difficulties arise, however, when we take those ancestral instincts to unnatural environments. And there is no more unnatural environment for a human brain than a
financial market.
Dangerous Setting: The Lizard Brain Loses Money on Wall Street
While the !Kung San can find reliable clues to make good decisions, investors face a very different situation. As we have discussed and shown repeatedly throughout this book, we tend to buy when we ought sell, and vice versa. By its very nature, investing requires us to be forward looking to anticipate future events. Our lizard brains, however, are designed to look backwards. Thus, the lizard brain causes us to be optimistic at market peaks (after rises) and to be pessimistic at market bottoms (after falls).
This backward-looking aspect of the lizard brain works well in natural tasks, even those that are very complex. For example, it is better to pick the closer of two identical animals. Thus, a !Kung San hunter should always pick the fresher of two identical trails. Furthermore, such a hunter can learn how to best use even extremely subtle signs that might lead to success.
In hunting, the relationship between information and success tends to be invariant. Precisely that which worked in the past is most likely to work in the future. Accordingly, the lizard brain is built to look for patterns in what worked in the past.
There are no similar rules in investing. Should we, for example, buy the stocks of fast-growing companies? Perhaps, unless too many other investors are also buying the stocks of fast-growing companies. If so, then the stock prices of these companies will be overvalued, and we’d be better off selling them.
Investing is fundamentally different from many ancestral tasks. Rather than do what worked best in the past, investing requires staying a step ahead of others. Thus, there can be no stable relationship between information and the correct course of action. This attempt to stay one step ahead of others, who are also trying to be one step ahead of you, leads to some strange statements.
Only in investing can you say, “As expected, Microsoft’s earnings exceeded expectations by more than expected. In after-hours trading, the stock is falling because the earnings surprise was smaller than was widely anticipated.”
For investing, the only rule is to predict what everyone else is doing, and move to profit from their behavior. Investors who do what comes naturally—or who use a fixed rule based on fundamental data—tend to become prey.
Investing is therefore the ultimate cognitive situation where we need precisely to restrain our instincts in order to make money. Unlike neutral games of chance, or ancestral problems like gathering and hunting, financial success means suppressing our “gut” response.
All of the irrational investing tips in this chapter are methods to prevent our less analytic parts from making our financial decisions. In short, to make money we need to shackle the lizard brain and throw away the key.
Shackle the Lizard Brain Investing Lesson #1: Don’t Trade Emotionally, Unless You Are Tom Cruise
In a debriefing of his flying in Top Gun, Maverick (played by Tom Cruise) is criticized for risky flying. Civilian contractor Charlotte “Charlie” Blackwood (played by Kelly McGillis) says, “You perform a split S? That’s the last thing you should do. The bandit is right on your tail—What were you thinking here, Maverick?” to which he replies:
You don’t have time to think up there. If you think, you’re dead.
Maverick is the ultimate instinctual pilot. Because he’s got great natural skills, he can win even with unconventional tactics. The analysis of Maverick’s split S ends with, “Maverick makes an aggressive vertical move here, comes over the top, and defeats the bandit with a missile shot. The encounter was a victory, but we’ve shown it as an example of what not to do.”
Similarly, some people can make money almost by instinct. In January 1987, I was visiting the New York offices of the legendary trader Paul Tudor Jones II. He was not in the office, but rather was on a chartered jet flying out to the Super Bowl in California.
Paul called the office for a market update. In those days it was harder to stay current with market prices because the Internet was rudimentary and wireless technology was not well developed. Thus, when Paul called from the plane he didn’t have any current information on the market.
Paul had started the day thinking that stocks would rise, and the previous day he had purchased what can be described as “a boatload” of S&P futures. So when he called to ask where the market stood, the higher the market, the more money he would have made. At the beginning of the call, Paul received some good news; the market was up a lot, and he had made some millions of dollars.
Just moments into the call, however, the stock market began to fall precipitously. As Paul heard the prices change, he asked to be patched through to the exchange floor in Chicago where the S&P futures trade. Shouting from his jet into the phone, patched through a noisy connection, I heard Paul sell all of his stock position—“get me out, now.” In just a few moments the voice from Chicago told Paul that he was out. With a quick reaction to a fast-moving market, Paul exited his position for a hefty profit.
I was then surprised to hear Paul instruct Chicago to sell even more stock futures. Since he didn’t own any, these additional sales created a short position where he would profit from a further market decline. In the space of just moments Paul had gone from a massive and profitable bet that stocks would go up to a massive bet that stocks would go down. Throughout the next few hours, stocks did, in fact, decline substantially and this earned Paul millions more.
“Gutsiest move I ever saw.” Maverick’s rival Slider whispers this about the risky and successful split S just after the official criticism of the maneuver. Paul Tudor Jones’s instantaneous reversal—from betting on stocks to betting against stocks—qualifies as the gutsiest trading move that I ever saw.
In Top Gun, the instructors suggest that the other pilots learn not from the instinctual Maverick, but rather from the unemotional pilot Ice Man (played by Val Kilmer). Similarly, while we might all wish we could trade like Paul Tudor Jones, we probably should not attempt to mimic the instinctual nature of his trading.
Recall from Chapter 3 that Professor Odean finds typical investors tend to make precisely the wrong moves. The nonprofessionals in Odean’s study tended to buy bad stocks and sell good ones. For these investors the instinctual split S moves tend to lead to losses, not profits.
Professor Odean has published another study that confirms his earlier finding that trading is dangerous to most people’s pocketbook. As with the previous work, this second study (coauthored with Professor Brad Barber) examined the brokerage accounts of thousands of individual investors. The goal was to look at the difference between men and women, and it has the provocative title of “Boys Will Be Boys.”12
In what way were boys being boys in this study? Professors Barber and Odean found that men in this study were worse investors than women. Per each dollar invested, men earned significantly less money than women. In investigating the reasons for the gender difference, it turned out that men traded 45% more frequently than women.
Every trade is costly so all other things being equal, the more an investor trades, the less money at the end of the year. All that extra trading definitely cost men. How about the actual stock selection? Were men or women better at picking winning stocks?
Professors Odean and Barber found that men and women are equally bad at picking stocks. On average, every trade cost the investors money as compared with not trading. Men did worse simply because they traded more. The study concludes, “Men lower their returns more than women because they trade more, not because their security selection is worse.”
Conclusion: Never trade emotionally, and trade as little as possible. If you can trade like Paul Tudor Jones II or fly a jet like Maverick, then you don’t need any advice.
Lesson #2: Never Trust Anyone, Not Even Yourself
During the technology bubble of the late 1990s, one of the best ways to make money was to get some stock at the initial public offering (IPO) of a company. The most famous of these IPOs was that of theglobe.com whose stock went up by more than 600% on the first day.
Of theglobe.com’s stock at the offering price, $10,000 netted a profit of $60,000 in a matter of hours. Sure beats the day job! Dozens of other IPOs had enormous first-day rises.
How do we get our hands on some of that IPO stock? In Glengarry Glen Ross a group of real estate salespeople ask a similar question. In a tough environment where sales are lagging, Alec Baldwin is brought in to motivate the team.
Baldwin arranges a contest: Whoever sells the most in the next week will earn access to the coveted (and closely guarded) “Glengarry Glen Ross leads.” These contain the names and contact information for people who are very likely to become buyers. With the promise of easy money, the salespeople do everything they can (legal and illegal) to get their hands on those golden leads.
In the bubble, people did all sorts of things to get into IPO stocks. I was never invited to participate in any of this, and I watched others with envy. On the day of the eToys’ IPO, for example, my friend Judith told me about an acquaintance who had made $20,000 “trading” the stock. When I inquired further, I learned that this brilliant trade was caused by the grant of some of the IPO stock through a contact in the company. In the bubbly IPO environment of the time, this was simply a gift, not a trading success.
Mean Markets and Lizard Brains Page 26