Social isolation produced pain in these people. In fact, the brain scan revealed the same electrical pattern as physical pain.6 So when we act differently from others we have to overcome our human desire to be part of the group.
This same study showed another interesting pattern. Those people who employed their cognitive abilities more felt less pain. To be precise, the people who had higher levels of brain activation in the prefrontal cortex had lower levels of activation in the pain centers. One of the main themes of this book, success requires using cognition to control the lizard brain.
2. Make the Investment Moves that Do Not Produce Dopamine
Another key to making money is buying investments that have not done well and selling those that have done well. As humans, we still share the “do-it-again” brain centers with other animals. As B.F. Skinner made famous, animals, including humans, tend to repeat behaviors that were rewarded. Thus, Skinner’s stimulus-response system leads us to love the investments that have made us money and hate the investments that have lost us money.
Our brains are actually bathed in pleasure-causing dopamine when we take the actions that have worked before. Spencer Johnson and Kenneth Blanchard captured the essence of this in their bestseller Who Moved My Cheese? In a world without change, the best way to find cheese is to return to the location where it was found previously. In a world with change, however, the best way to find cheese is to look somewhere new.
Financial markets are the worst environments in which to use stimulus-response processes. Precisely because most people fall in love with past winners, they tend to buy the investments that have gone up, not the ones that will go up. Thus, to make the correct financial decisions, we need to do exactly the opposite of what has been giving us our emotional reward. To make money, we need to break the dopamine addiction (at least in this area of our lives), and use our cognitive ability to control our behavior.
Those who want to follow the Mean Markets and Lizard Brains advice to reduce financial risk will have to do precisely the opposite of what has worked well for a generation.
3. Make an Emotionally Realistic Financial Plan
A third key to making money is to understand our own limits and to make a financial plan that we can execute.
In Plato’s Apology of Socrates, the oracle of Delphi says that Socrates is the “wisest of men.” Socrates is aware of his own flaws and so asks, “How can this be?” After a conversation with a man widely deemed to be brilliant, Socrates concludes, “I do not suppose that either of us knows anything really beautiful and good. I am better off than he is, for he knows nothing, and thinks that he knows; I neither know nor think that I know.”
Socrates is the wisest of men, Plato suggests, precisely because he is aware of his flaws. Similarly, successful investors must be aware of their own irrationality.
In some unusual circumstances, people sometimes execute the perfect financial plan. For example, in 1987, a Massachusetts man (who wishes to remain anonymous) bought 1,000 shares of EMC for $15.75 a share. He held on to the shares for 13 years, by which time they had become 48,000 shares (because of splits) each worth more than $100.00.7
For 13 years, this investor patiently rode his profits and converted $16,000 into almost $5 million. In contrast, most investors make the mistake of harvesting their profits too quickly and riding their losses.
Even great investors tend to sell their winners too soon and to never sell their losers. In the 1940 investment classic Where Are the Customers’ Yachts? Fred Schwed, Jr. writes, “When a great and sagacious financier dies, and the executors go through the strongbox, they usually find, tucked well away in the back, bundles of the most hopeless securities whose very names have been long since forgotten.”8
So how did our EMC holder resist the temptation to take profits? He simply forgot that he owned the stock! He originally bought 3,000 shares and sold 2,000. He didn’t know that he owned any shares until he was notified by a state agency about his “inactivity.”
Unless we can similarly forget about our investments, we have to anticipate our weaknesses. A frequent problem is that an investor has a “perfect” plan, but then makes an emotional trade at precisely the wrong time. Thus, in my low-risk financial plan, I keep enough money invested in stocks to stave off the lizard brain. Each person has to craft a customized financial plan that anticipates and preempts moments of irrationality.
4. Be Tough Enough to Stick to a Plan
When I was in middle school, my friend Paul ran the 600-yard run (the longest event) in the school’s annual athletic competition. Opposing him was Jimmy, one of the bullies and part of the in-crowd. My friends and I desperately wanted Paul to win, and we gathered round him minutes before the start.
Paul knew that the race had implications for all his friends and for the school’s entire social order. He spoke to us in a serious and calm manner. Here’s what he said: “I don’t want you to get nervous if I’m behind in the beginning; my strategy is to come from behind. Don’t worry, I’m going to win.”
The race was three laps and—as Paul had forewarned—after one lap he appeared hopelessly behind. Confident in his certain victory, Jimmy started celebrating and gesturing to his fellow bullies in the crowd. On the final lap, Paul accelerated and easily passed a tired Jimmy.
John Maynard Keynes remarked that markets tend to stay irrational for longer than an investor can stay solvent. Therefore, the investor who seeks to profit from irrationality has to anticipate being behind in the race for a long time. The goal, of course, is to have more money in the long run, not to be in the “lead” for a while.
Even the legendary Warren Buffett had to endure scorn during the late 1990s because he refused to buy bubble stocks. Buffett avoided overpriced stocks, which became even more overpriced before the bubble popped. Accordingly, he missed out on the ephemeral gains and many claimed that Buffet had “lost his mojo.” Buffet’s exceptional mental toughness allowed him to persist and prosper. Unlike most people, he never deviated from his plan.
Tame the Lizard Brain and Convert Mean Markets into Opportunity
Taming the lizard brain by following the Mean Markets and Lizard Brains advice is not easy. Quite to the contrary, it is very hard. The fact that making money is difficult is precisely what makes it possible. If it were easy to make money from others’ irrationality, then the opportunities would vanish.
Interestingly, financial success does not require fancy mathematical skills or genius-level IQ. No, it requires something far more rare and difficult. To make money investors need what Dan Goleman labels emotional intelligence (EQ):
EQ is not destiny—emotional intelligence is a different way of being smart. It includes knowing your feelings and using them to make good decisions; managing your feelings well; motivating yourself with zeal and persistence; maintaining hope in the face of frustration; exhibiting empathy and compassion; interacting smoothly; and managing your relationships effectively.9
Goleman argues that attaining one’s goals in life requires emotional intelligence more than IQ. Similarly, successful investing requires the extremely rare quality of EQ. To profit from market excesses requires self-knowledge, self-confidence, endurance, and mental toughness. The successful investor has to face ridicule and must live with underperformance for extended periods.
“Money won is twice as sweet as money earned,” said Paul Newman to Tom Cruise in The Color of Money. Similarly, I find money gained through savvy investing to be far sweeter than wage income.
Markets are irrational, and our backward-looking, pattern-seeking lizard brains push us to lose money. Investors who let the lizard brain make financial decisions tend to buy at market tops and sell at market lows. Because our instincts are exactly out of sync with financial opportunity, markets can be mean.
However, it is the very irrationality of markets that provides the opportunity to make sweet profits. Financial success is based on using emotional intelligence to shackle the lizard brain. Fortun
ately, EQ can be increased by diligence, introspection, and discipline. Therefore, any investor willing to work to understand and tame the lizard brain can transform mean markets into money and satisfaction.
Update since the First Edition
U.S. financial markets have been “mean” in recent years in two senses. First, returns on all major U.S. investment classes have been low (Figure 11.1). Since 2005, the inflation-adjusted return on Treasury bills and 10-year Treasury bonds has been under 1% per year. U.S. equity returns, including dividends, have come in around 2%. Finally, U.S. real estate has been a problematic investment area. So U.S. markets have been miserly in producing low returns in stocks, bonds, and real estate.
FIGURE 11.1 U.S. Returns Have Been Low
Sources: Robert Barro, Quarterly Journal of Economics; U.S. Federal Reserve; Dow Jones
FIGURE 11.2 U.S. Equity Premium Has Been Low
Sources: Robert Barro, Quarterly Journal of Economics; U.S. Federal Reserve; Dow Jones
Second, the premium for taking the risk of owning stocks had been extremely low (Figure 11.2). In recent years, U.S. stocks have returned about 1% more than ultra-safe, no-risk T-bills. This low equity premium contrasts sharply with the prior 100+ years during which U.S. stocks yielded a an average of 6.6% more per year than T-bills. Beyond equities, the general equation of “more risk = more return” has been reversed in other important areas. The 2007 credit crunch, for example, involved schemes that used leverage to increase risk. The goal of increased risk was increased returns, but the result was ruin.
What’s Next?
U.S. financial markets have been disappointing for some years now. Will the future bring good times or more disappointment? More disappointment is the short answer. The first edition predicted a long period of low returns to risk. It took a generation to teach the lizard brain to love risk, and the unwinding could take just as long. All of the data of the last few years are consistent with the original premise of the book; I see no reason to change.
When will it be time to return to risk? Perhaps rather than predict the duration of the current malaise, we should focus on three signals that will give us a green light.
Low Exposure to Risk
When it is time to buy risk, people will generally not have risky financial positions. Stocks are riskier than bonds. So when it’s time to buy risk, stocks will be a small percentage of people’s portfolios. Similarly, being a debtor is risky, so a sign of a turn will be low levels of debt. This will be evident in a high U.S. savings rate, high levels of home equity, and a current account surplus.
Low Prices to Buy Risk
When it is time to buy risk, the price will be low. This will include low equity valuations and equity dividends that exceed bond market yields. Real estate should produce positive cash flow without any assumption of appreciation.
Popular Sentiment against Buying Risk
There is no surer indicator of profitability for an investment than scorn. When it is time to invest in risk, the folk wisdom of the day will tell us that only fools take risks. Perhaps the most salient, recent example is U.S. home prices. Just a few years ago, real estate was considered a “can’t lose” investment. Beware of “can’t lose” investments, as they are the ones that invariably lose.
Rather than look for “can’t lose” ideas, we should look for ideas that are considered idiotic and “can’t win.” This is true for specific investment classes, as well as for financial risk in general. We should buy risk when financial safety is in vogue. For example, a general belief that debt is evil would be a good sign for strong returns to risk. Similarly, look for a time when standard financial advice says that we should eschew stocks.
Conclusion: An Ancient Brain in Modern Markets
Financial markets are frustrating because our brains are built to look backwards. Our lizard brains will never want to buy the investments that will go up, but rather continuously select investments that have gone up. This equation for frustration is as old as the markets, and will not change.
While the lizard brain will always frustrate us, the specifics of market meanness will reverse. Today, most of us want to buy risk even though it is overpriced. When risk becomes a good buy, most people will be disgusted with risk and cowering inside financial bomb shelters. The good news is that irrationality provides a never-ending supply of opportunities for those equipped with self-knowledge and the courage to be different.
Notes
Preface 1 Johns Manville, www.johnsmanville.com.
Chapter 1 Introduction 1Personal communication. See Chapter 7.
2 Leading Wall St. Firms’ Asset Allocation Recommendations (for 2004). Dow Jones Newswires, December 31, 2003.
3 Investment Company Institute, www.ici.org, 2004 Fact Book, 88.
4 Federal Reserve Survey of Consumer Finances, www.federalreserve.gov.
5 Berkow, R., The Merck Manual of Medical Information: Home Edition (New York: Pocket, 1999), 1303.
6 U.S. Food and Drug Administration. Aspirin for Reducing Your Risk of Heart Attack and Stroke: Know the Facts. www.fda.gov.
Chapter 2 Crazy People 1Those interested in more detail can see: Glimcher, P. W., Decisions, Uncertainty, and The Brain: The Science of Neuroeconomics (Cambridge, MA: MIT Press, 2003).
2 Medawar, P.B., An Unsolved Problem of Biology (London: H.K. Lewis, 1952), 3.
3 Harig, B., “Woods ‘Uncomfortable’ with His Game,” ESPN.com, April 26, 2004.
4 Tversky, A., and D. Kahneman, “Extensional versus Intuition Reasoning: Conjunction Fallacy in Probability Judgment,” Psychological Review 90 (1983): 293-315.
5 Burrough, B., and J. Helyar, Barbarians at the Gate (New York: HarperCollins, 1990).
6 Burnham, T., and J. Phelan, Mean Genes (Cambridge: Perseus, 2000), 83-104.
7 Tversky, A., and D. Kahneman, “Evidential Impact of Base Rates,” Judgment under Uncertainty: Heuristics and Biases, D. Kahneman, P. Slovic, and A. Tversky, eds. (Cambridge: Cambridge University Press, 1982), 154.
8 Svenson, O., “Are We All Less Risky and More Skillful Than Our Fellow Drivers?” Acta Psychologica 47 (1981): 143-148.
9 Ross, M., and F. Sicoly, “Egocentric Biases and Availability and Attribution,” Journal of Personality and Social Psychology 37 (1979): 322-336.
10 Peters, T.J., In Search of Excellence (New York: Harper & Row, 1982), 56.
11 Lichtenstein, S., B. Fischhoff, et al., “Calibration of Probabilities,” Judgment under Uncertainty: Heuristics and Biases, D. Kahneman, P. Slovic, and A. Tversky, eds. (Cambridge: Cambridge University Press, 1982), 306-334.
12 Roth, G., and M. Wulliman, eds., Brain Evolution and Cognition (New York: Wiley, 2001), Chapters 16 and 17.
13 Minsky, M.L., The Society of Mind (New York: Simon and Schuster, 1986).
14 Lech, R.B., Broken Soldiers (Urbana: University of Illinois Press, 2000).
15 Cialdini, R.B., Influence: The Psychology of Persuasion, rev. ed. (New York: Quill/ William Morrow, 1993).
16 Gazzaniga, M., The Mind’s Past (Berkeley: University of California Press, 1998).
17 McGurk, H., and J. MacDonald, “Hearing Lips and Seeing Voices,” Nature 264 (1976): 746-748.
18 Harlow, J.M., Recovery from the Passage of an Iron Bar through the Head (Boston: David Clapp & Son, 1869).
19 Thaler, R.H., The Winner’s Curse: Paradoxes and Anomalies of Economic Life (Princeton, NJ: Princeton University Press, 1992); Gilovich, T., D. Griffin, et al., eds., Heuristics and Biases: The Psychology of Intuitive Judgment (Cambridge: Cambridge University Press, 2002).
20 Schwager, J., Market Wizards: Interviews with Top Traders (New York: Prentice Hall Press, 1989), 117-140.
21 Guth, W., R. Schmittberger, et al., “An Experimental Analysis of Ultimatum Bargaining ,” Journal of Economic Behavior and Organization 3, no. 4 (1982): 367-388.
22 Roth, A.E., “Bargaining Experiments,” Handbook of Experimental Economics, J.H. Kagel and A.E. Roth, eds. (Princeton, NJ: Princeton University Pre
ss, 1995). Roth, A.E., V. Prasnikar, et al., “Bargaining and Market Behavior in Jerusalem, Ljubljana, Pittsburgh, and Tokyo: An Experimental Study,” American Economic Review 81, no. 5 (1991): 1068-1095.
23 Hoffman, E., K. McCabe, et al., “On Expectations and the Monetary Stakes in Ultimatum Games,” International Journal of Game Theory 25 (1996): 289-301.
24 Cameron, L., “Raising the Stakes in the Ultimatum Game: Experimental Evidence from Indonesia,” Economic Inquiry 37, no. 1, (1999): 47-59.
25 Henrich, J., R. Boyd, et al., “In Search of Homo economicus: Behavioral Experiments in 15 Small-Scale Societies,” American Economic Review 91, no. 2 (2001): 73-78.
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