Mean Markets and Lizard Brains

by Terry Burnham

  The negative alternative, however, is that productivity growth will recede toward historical averages. If so, then we may be stuck with the debts we have, and the attendant consequences. Therefore, high-productivity growth appears to be necessary if we are to escape our debts.

  With high enough productivity, financial assets can continue to prosper. This is possible even though stocks cannot outgrow the economy, interest rates cannot continue to decline, and the United States will stop consuming more than we produce. Thus, productivity is the single fundamental indicator that I will watch most closely in coming years.

  The risk of being a conservative investor (owning low-risk investments) is missing out on a productivity-led boom. If financial markets continue to climb, then the low-risk investing strategy will earn lower returns than a higher-risk strategy.

  The Pain of Low-Risk Investments

  A Harvard faculty colleague of mine ends his course on decision making by giving two bits of advice. First, if you smoke, quit. Second, try to be less envious. Of these two suggestions, quitting smoking might be the easier one. Those who shift to a lower-risk strategy must face the possibility that the risky investments they sell will continue to soar.

  Very few people succeed without setbacks. Early in the life of my biotech startup, Progenics, I met with Paul Tudor Jones II, a lead investor. He asked how things were going, and I responded, “Fine”. He was seated and I was standing up on the opposite side of his desk. Paul rose, walked to my side of the desk, and sort of backed me up against the wall. He said, “You must anticipate being pressed to your limits—and that’s if you succeed.”

  Paul was prescient and along the way to Progenics’ success, we had to weather several crises, including twice almost going broke and missing payroll. I felt tremendous stress, particularly because we had hired scientists from around the world and some of them had young children. One of these near-bankruptcy episodes was so stressful that some of my hair stopped growing, and I had to receive cortisone shots to revive the follicles.

  Similarly, a low-risk investing strategy is likely to be stressful. One has to anticipate being pressed to one’s limit. With near certainty, there will be times when everything appears rosy. At such times, our tendency to be envious will make us want to jump on the risk bandwagon. Such emotional points, we have learned, are likely to be terrible moments to change strategy.

  If productivity stays significantly above historical levels, and financial risk continues to be rewarded, we will all gain. Even those of us who have a conservative financial plan. The benefits we will receive in a rosy world are direct and indirect. Most important, our opportunities will be vastly expanded, wages will rise, and the assets we own will increase in value.

  In addition, even conservative investors will gain from national prosperity. Current projections show that the retirement of the baby boomers will put serious pressure on the U.S. budget. The annual budget deficit that currently stands at half a trillion dollars could soar to several trillion. In such an environment, it is inevitable that taxes will rise and benefits such as Social Security will fall.

  Productivity and prosperity can save us from the baby boom retirement disaster. If they do, our taxes will be lower, our government benefits higher, and our opportunities far greater. Thus, even those who own no risky assets will earn a handsome return if the financial markets continue to rise.

  Unfortunately, envy seems to be an integral part of human nature. In fact, the tenth commandment says, “You shall not covet your neighbor’s house; you shall not covet your neighbor’s wife, or his manservant, or his maidservant, or his ox, or his ass, or anything that is your neighbor’s.” The need to include this prohibition in the Bible reinforces the idea that envy and covetousness are part of human nature.

  One technique to suppress human urges including envy is to construct a “frame,” or a way of viewing investments. In this manner, I suggest viewing lower-risk investments as insurance. No one is unhappy when a car insurance policy is not used. We don’t get mad if we pay money and then get through the year without an accident.

  If we take out insurance in the form of a low-risk investment strategy, we should similarly rejoice when that insurance is not used. Thus, we should think of our low-risk investments as a guarantee against an unpleasant world, or “dry powder” for those moments when prices become irrationally low. Such framing is useful, but the problem of decreasing risk is not so easily solved because our lizard brains create fundamental, psychological barriers.

  The Barrier to Low-Risk Investing

  Near the end of his career, a group of students allegedly played a joke on the famous behaviorist, Professor B.F. Skinner. During a lecture the students agreed upon the following secret plan. Every time Professor Skinner moved to his left, the students would smile at him. In contrast, whenever he took a step to his right, the students would frown and look at their notes.

  By the end of the lecture, Professor Skinner was standing at the side of the room with his left arm essentially pinned against the wall. He had been induced to move to his left by the subtle signals sent by the students.

  A central view of Professor Skinner’s approach is that all animals, including people, learn to repeat pleasurable acts and to avoid those that are painful. Human brains are built with a “stimulus-response” mechanism that helps us navigate through the world.

  I’m reminded of my own stimulus-response behavior whenever I drive to the Boston airport. As I enter the tunnel that leads under the harbor, my mind invariably flashes to the state trooper who pulled me over at that spot for speeding. As I recall the unpleasant memory of turning the corner and seeing him with a radar gun, I slow down. I may get ticketed for speeding again in my life, but never in the same spot as this previous ticket.

  Professor Skinner’s students played a trick on him. Stimulus-response behavior modification can be more subtle than a state trooper with a siren or a burned hand on a hot stove. Humans are social creatures, and we get pleasure and pain from our interactions with each other. With their facial expressions, Skinner’s students “rewarded” him for his moves to the left and “punished” him for moves to the right. Unconsciously, he began to do more of the rewarded behavior and less of the punished, thus leading him to be pinned against the wall.

  Professor Skinner was extreme in focusing on the conditioning effects of rewards and punishments, and ignoring the mental processes driving behavior. Even though the world now has a more nuanced and better understanding of behavior than Professor Skinner, no one denies the importance of stimulus-response. We humans share with other animals the brain machinery that teaches us to do again that which rewarded us in the past.

  Our human stimulus-reward system can produce destructive behavior. A reformed crack addict whom I chatted with described his previous lifestyle as follows: A typical night begins with a group of friends all carrying as much money as they can scrounge up. The group drives (at least in California) to a crack house and smokes some drug.

  The evening alternates between bouts of consuming crack and down time. The group generally travels between crack houses. The journey ends only when every penny has been spent. Almost every crack house includes women who will trade sex for drugs. Early in the night, when money is relatively easy, crack plus sex is better than crack without sex and worth the expenditure. Later in the night, when money is tight, the extra pleasure of sex is not worth the cost. The binge ends when everyone is broke, and the addicts find someplace to sleep. When they wake, they seek money to begin the process again.

  One night after dropping off his buddies by car, my source told me that he chanced upon a big “rock” of crack that had somehow been left in the backseat. He couldn’t believe his good fortune and enjoyed this unexpected final high for the night. For years afterwards, he would always look in the same spot when he got out of his car. In a manner that would have made Professor Skinner smile, this addict’s brain had been altered by a potent reward.

  Like
a crack addict, we are built to look for rewards in the places (both literally and metaphorically) of our past joys. Presumably, this stimulus-reward system was adaptive for our ancestors who lived in their natural environment. For rats in cages, and for humans in industrialized societies, the quest for dopamine can get us into serious trouble.

  In Austin Powers, our hero, the international man of mystery, says, “Only two things scare me, and one of them is nuclear war.” Similarly, two things scare me about our human stimulus-response system, and one of them is drug addiction. While some people’s lives are destroyed by the maladaptive activation of the stimulus-response system by drugs, almost all of us lose money because of its effects on our finances.

  We are built to seek the dopamine high that comes from successes. For our ancestors, this system led them toward useful behaviors. In the financial world, however, this system is almost perfectly designed to create poverty. Investing is a changing game where the best strategy today is almost never the best strategy of yesterday. So our brains are built to replicate successful behaviors, but the financial markets punish such behavior.

  Those who invest by stimulus-response will tend to do that which has worked, not that which will work. For example, after the huge stock market gains in the 1990s, investors ploughed a record $309 billion into stock mutual funds in 2000, just in time for the stock market bubble to burst. Over the two years of 2001 and 2002, investors invested a total of just $4 billion into stock funds, again timed perfectly to miss the huge stock market rally in 2003. In 2003, investors ploughed over $150 billion into equity funds.4 To date, stocks have lost ground in 2004 (through mid-July). The backward-looking, stimulus-response system of investing is not profitable.

  On a far grander scale, we have been rewarded for taking financial risk for a generation. The lizard brain is built to continue this behavior. This presents a significant barrier to taking a low-risk financial strategy.

  How Little Risk Can You Stand?

  My Harvard retirement money is deposited with a large investment company (chosen by Harvard). On their website, the company provides investment advice that is tailored to each individual. The investor answers a set of questions including attitudes toward risk and time until retirement. From these answers, a computer program suggests how much money to invest in stocks, bonds, and risk-free cash.

  The computer advisor suggests that I invest 80% of my retirement money into stocks! I completely disagree with this recommendation, but I answered every question honestly. Why the disagreement?

  Standard investing advice (and my firm is no different from most others) is based on two key premises. First, markets are efficient. Second, because markets are efficient, investors who want to make a lot of money have to take a lot of risk. Because stocks are risky, they must be profitable. (I’m not making this bizarre logic up.)

  So this mainstream view says stocks provide the highest return, with two caveats. Investors must be in the game for the long run, and they must be able to take the ups and downs of the stock market. Thus, standard investing advice asks two main types of questions. Is the investor in the game for the long run? And can the investor take the bumps along the road? If so, back up the truck and buy stocks.

  If markets are efficient, what should I do? I’m definitely in the investing game for the long run. Furthermore, I love volatility. The thrill of the ups and downs is so powerful for me that I even understand the wacky views of compulsive gamblers.

  In Double Down, for example, Frederick and Stephen Barthelme explain how they gambled away their $250,000 inheritance. They explain that winning was better than losing, but losing was better than quitting.5 Although I don’t gamble, I love risk enough to understand the Barthelme brothers’ odd priorities.

  So if markets are efficient, then a risk-loving guy like me with a long horizon ought to buy risky stocks. If markets are not efficient, however, it is possible to make high returns without taking risk. Academic studies have found significant time periods when low-risk investments have high returns. The Mean Markets and Lizard Brains conclusion is that we are living in one of these time periods.

  If the Mean Markets and Lizard Brains conclusion is correct, then it is possible to get the highest returns along with the lowest risk. Thus, the investments that are the safest may also end up with the highest return.

  Whenever somebody gives an opinion, I think of the economic concept of “revealed preference.” It cautions us to observe behavior and not listen to words.

  Some years ago, my father-in-law, Joel, learned about revealed preference. During the early declines following the stock market bubble, I suggested that he sell the stock that he owned through a money management firm. Joel notified the firm of his decision to sell. One of the firm’s bosses called to ask why Joel was “getting out at the bottom.” Joel asked where the boss had his personal money invested and was told, “I’ve been in cash for quite a while.” Joel hung up the phone and cursed under his breath.

  A similar lesson is found in Swingers, where heartbroken Mike (played by Jon Favreau) learns dating rituals from suave Trent (a.k.a. “Big-T,” played by Vince Vaughn). Mike asks, “After I get a woman’s phone number, how long do I wait to call?” Big-T says, “If you call too soon you might scare off a nice baby who’s ready to party,” and concludes, “three days is kind of money.” Mike then asks the revealed preference question about the three-day rule: how long until Big-T will call his “baby”? Big-T answers, “Six days.”

  So a fair question is whether I’ve taken my own advice. The answer is not completely. In spite of truly believing that the low-risk approach is the way to go, I still have 10% of my money invested in stocks, including some high-flying Internet stocks. Why? Ten percent in stocks is the lowest amount of risk that I can take emotionally at this time.

  A small risky investment is my effort to calm the lizard brain. During my entire investing life, risky investments have paid the highest return. Thus, my lizard brain constantly goes back to those heady days when there was easy money to be made. Although I’m using my prefrontal cortex to restrain the lizard brain, Ten percent is the lowest amount of risk that I can stomach these days.

  The acid test of an investment strategy is how one feels when the strategy isn’t working. When the stock market is soaring, and my low-risk investments are earning close to zero, my lizard brain screams, you fool! Buy stocks! On those days, I need to have some money invested in stocks or the lizard brain will break out of its cage and buy risk at precisely the wrong time.

  Take as little risk as you can stand. This is precisely the opposite of the mainstream advice grounded in the view that markets are efficient. In the fantasy world of efficient markets, we should take as much risk as we can stand in order to get those high stock market returns. In the real world of today’s mean markets, perhaps we should take as little risk as we can stand.

  Profiting from Manias and Crashes

  The Mean Markets and Lizard Brains analysis suggests that we are in the midst of a new sort of bubble. While stocks, bonds, and real estate do not appear to be in bubble mode individually, the bubble may be in risk-taking itself. A generation of reward for taking financial risk has pushed us to take too many costly gambles.

  The Mean Markets and Lizard Brains conclusion is that most people should reduce their level of financial risk. Our lizard brains have extrapolated from a golden generation that rewarded risk, and pushed us toward the risky investments that worked so well for so long. Unless productivity from the information revolution saves us, these risky investments are likely to disappoint.

  Thus, the Mean Markets and Lizard Brains prescription is to reduce financial risk in order to be prepared for future opportunities. This advice is, of course, tempered and customized by individual circumstance and tastes.

  If humans were the rational, cool-headed robots of economic theory, then achieving our financial goals would be easy. Because we are exactly the opposite—emotional beings subject to bouts of irrational
moods and crazy decisions—financial success is difficult. In particular, in several key areas we need to lean into our human nature in order to profit from financial opportunity.

  Four Keys to Profiting from Mean Markets

  1. Be Different

  A key to making money is to buy when others are selling and sell when others are buying. In other words, in order to make money we have to do the unpopular behavior that others aren’t doing.

  Running against the mob is difficult because we are built to want to do what others are doing—we want to be part of the group. One study found that social isolation creates pain. In the study, three people play a ball-tossing game on a computer screen while one sits inside a brain scanner. The person in the brain scanner is told that the two other players are real people, but they are actually fake people controlled by the experimenter.

  The experiment looked at the brain in two conditions, being part of the group or being ostracized. In the first, the real person is part of the game and gets the virtual ball frequently. In the second, the two artificial players exclude the real person by passing the ball back and forth.