Iconoclast: A Neuroscientist Reveals How to Think Differently

by Berns, Gregory

  It seems like a roundabout way of explaining a quirk of human behavior, but it explained why people seem to have an aversion to risk. There are several definitions of risk, but from an economic point of view, risk is anything where there is a possibility of loss. Playing the St. Petersburg game is a risky decision because someone will lose, either the person placing down the $20 or the person doubling the pot. Bernoulli’s solution was elegant because he said that what appeared to be an aversion to risk stemmed from the way the human mind distorted the value of money. The idea could be extended to anything else that conferred utility based on the quantity consumed—food, for example.

  To put risk aversion in the context of the previous two chapters, think of it as fear of failure. Bernoulli said that people look at, say, $1,000 but don’t treat it as ten times more than $100. In other words, their perception of the value of money is distorted. Why should that be? Because they are afraid of the alternative. The fear of losing money, aka the fear of failure, distorts the functioning of the perceptual system in the brain. The end result is, for lack of a better word, an irrational decision. Only the iconoclast resists this type of perceptual distortion.

  Suppose that you did not distort utility in the manner Bernoulli suggested. Suppose the utility you obtained from a given amount of money exactly tracked the face value of the money. Your utility function would be a straight line, and you would behave in an objective, risk-neutral manner. This is precisely the characteristic that disciplined money managers have. In fact, it is the only way to invest money rationally. It also goes against deep biological biases to behave the way Bernoulli suggested, and it is why there are so few people who can manage risk objectively. How the brain perceives value and utility suggests why most people (and animals) behave this way. But before getting to the neuro side of the story, we must first get to the twenty-first century in terms of economic theory.

  By the twentieth century, it became apparent that Bernoulli’s explanation of risk aversion was incomplete. Some argued that people are unwilling to play the St. Petersburg game because to do so would require a belief in unlimited resources available to keep the pot doubling. A dubious assumption in any gambling scenario, especially a bar. But the core idea of utility being the guiding principle behind decision making continued to hold sway. In 1944, the mathematicians John von Neumann and Oskar Morgenstern formalized the idea that all decisions could be understood if one assumed that individuals make choices as if they were trying to maximize their utility.3

  Von Neumann and Morgenstern said that when an individual is faced with a decision and must make a choice between competing alternatives, the person chooses the course of action with the greatest expected utility. The way to calculate expected utility, or EU, is similar to what Bernoulli suggested. You multiply the utility of every possible outcome by the probability that it will actually happen. Then you choose the action with the highest EU. Expected utility theory, or EUT, explains a great deal about decision making from a mathematical perspective. EUT also paints a clear picture of what is the best course of action to take from a rational perspective, and it remains the foundation of almost all economic models of human decisions.

  Despite its mathematical elegance, EUT may strike the average person as a completely unreasonable way to go about making decisions. It requires you to accurately gauge how you will feel about every possible outcome, and calculate the odds of each outcome actually occurring. The vast majority of people, in fact, do not consciously make decisions this way, but recent neuroimaging experiments suggest that the brain does perform calculations similar to this, even when the person is unaware of it. As it turns out, the people who actually do make decisions resembling what EUT predicts are probably the true iconoclasts. Everyone else suffers from a host of perceptual distortions that lead to a cornucopia of decision-making maladies.

  The Contrarian: David Dreman

  Buy low and sell high. This principle is so obvious, a monkey should be able to make money in the stock market, right? According to David Dreman, a sort of Yoda of contrarian investing, in fact it is this simple. If only you can set aside the fear of failure and the possibility of looking stupid while your peers surpass you.

  At age seventy, Dreman has weathered his share of market bubbles and crashes. He has written several best-selling books on contrarian investment, including Psychology and the Stock Market and Contrarian Investment Strategies: The Next Generation. In addition to his regular columns for Forbes, Dreman manages over $6 billion in assets through two mutual funds that adhere to the contrarian principles he espouses. He is the chairman of Dreman Value Management, which, in addition to the mutual funds, manages investments for select institutional and private investors. The Dreman High Equity Return Fund, which is sold through Scudder Funds, has delivered a ten-year annualized return of 11.2 percent, compared with 8.6 percent for the S&P 500 Index. The fund ranks in the top 20 percent of funds with ten-year records.

  Dreman’s core principle harks back to the father of investment advice, Benjamin Graham. This investment strategy centers on the idea of buying out-of-favor stocks, hence the contrarian label, and in the world of finance amounts to being an iconoclast. An out-of-favor stock, by definition, means that the bulk of the market finds the stock relatively unappealing. According to Dreman, these stocks are easily identified by straightforward measures of valuation. The simplest, and one proposed by Graham seventy years ago, is the price-to-earnings, or P/E, ratio. Dreman looks for stocks that are below the market average P/E and will often buy stocks that are in the bottom fifth.

  Dreman laughs when questioned about whether his strategy is really contrarian. He freely admits there is no big secret to his approach. “There are many good filtering tools to find stocks with low P/E ratios.” But Dreman is quick to add, “But most people don’t do this, even though statistically low P/E stocks outperform over time.” The problem, he says, is that most people, including professionals, can initiate the approach but have trouble following through with it. “The problem is totally anchored in psychology.”4 Actually, it is anchored in the brain’s perceptual systems.

  Deceptively simple, the P/E ratio is calculated by dividing the stock price by earnings per share. The P/E ratio represents how much the market values the company relative to what it is currently earning. High P/E ratios imply that the market believes a company will earn more in the future than it is currently earning. In other words, the company is expected to grow. The determination of what constitutes a high P/E ratio depends on several assumptions. If a company is not expected to grow, then it is in steady state. And if it is not growing, a steady-state company can only earn money by carrying on business as usual. The value of a company in this condition is roughly equal to its net operating profit divided by the cost of raising money. If the cost of raising money, through loans and shareholder equity, is 8 percent, then the steady-state valuation is 12.5.5 Thus, as a very rough benchmark, companies with P/E ratios greater than 12.5 are expected to grow in value by finding new customers and new markets. Less than that, the market expects the company to shrink.

  Companies with low P/E ratios, those that Dreman hunts for, may have low ratios for two possible reasons. The first is that the company is fundamentally solid, is growing earnings above the market rate, but for perceptual reasons, is out of favor with investors. These are the bargains Dreman tries to find, and according to him, they outperform the rest of the market over the long haul. But not everyone agrees with this sentiment. The second reason a company could have a low P/E ratio is that it is at the end of its life. According Michael Mauboussin, chief investment officer at Legg Mason Capital Management, “Low multiples [P/E ratios] generally reflect low (and justified) expectations.”6 Thus, a low P/E ratio, rather than being a bargain, as Dreman believes, could signal the imminent death of a company.

  Dreman is steadfast in his belief in the low-P/E approach to investment. Eschewing complicated technical analysis, he is also used to wearing the iconoclas
t label. Raised in Winnipeg, Canada, Dreman had an early exposure to the stock market.7 “My father was a very good commodities person, but he was actually a contrarian,” said Dreman. “So it’s very natural for me.”

  Recounting his early professional experiences, Dreman said, “When I was in my 20’s, I was a junior analyst in a Wall Street shop, and I tended to buy favorites. This was really a growth firm, but there was real pressure to buy what everyone else was buying. And this came from the top. I noticed the senior guys would meet their friends at dinners and charities and such, and they all liked the same stocks. It went all the way down the line.

  “Now the senior guys,” Dreman continued, “they had strong likes and dislikes. But there was also a belief that if you didn’t stay with these favorite stocks, you’d lose your accounts.” Dreman paused to think about this. “And if you’re an analyst, you might lose your job.”

  Referring to the peak of the Internet bubble, Dreman said, “We had a lot of clients in ’99 who moved out of our fund and said, ‘Value is all in the past!’ Some really good value managers quit, and others experienced value drift. There was enormous pressure to switch strategies. Even someone like myself, I stayed with it, but I didn’t know if our company would exist. It’s very hard to go against the crowd. Even if you’ve done it most of your life, it still jolts you.

  How does someone like Dreman resist the pull of the crowd? How does he resist the fear of standing alone? A calm temperament and self-confidence helps, but what about biological factors? A recent twist in the types of brain imaging studies being conducted has shed some light on the murky area of individual differences. Differences in brain function may explain why some people have the chops to go against the herd, while others fall in line.

  The Iconoclast Who Beats the Market: Bill Miller’s Approach

  Here’s the problem with the fundamental value approach: if it really worked, then everyone would use it. And if everyone used it, they would bid up the price of companies believed to be undervalued, and then they would no longer be undervalued. This is why Dreman deserves the label “iconoclast.” Now, many analysts, who make their living analyzing stocks, will argue that by uncovering certain types of information about the company that nobody else possesses, you can gain an advantage in the market. Or by analyzing past trends in prices and correlations between the movement of some assets with others, you can derive algorithms that will outperform the market as a whole. The problem is that everyone has access to the same information. So many individuals are active in the stock market that it becomes extremely unlikely that someone will gain an advantage over the other people. This inability to gain an advantage, in a nutshell, is known as the efficient market hypothesis, or EMH.

  Formulated in the 1960s by Eugene Fama, an economist at the University of Chicago, the EMH says that financial markets are informationally efficient. This means that the price of any asset represents the collective wisdom and knowledge of all the people trading in the market. As a direct result, the EMH says that it is impossible to consistently outperform the market. You may do so transiently by luck, but not for long. The flip-flopping of mutual fund rankings is broadly consistent with the efficient market hypothesis. But even here, a slight discrepancy remains. A very small group of funds and fund managers do tend to do better than others on a consistent basis.

  Bill Miller, the manager of the Legg Mason Value Trust, with $20 billion in assets, beat the S&P 500 fifteen years in a row, a streak that finally came to an end in 2006. By that statistic alone, Miller qualifies as either the luckiest of all fund managers or the most iconoclastic. Believers in the EMH say that Miller was the beneficiary of a lucky streak, and in the grand scheme of the market, he will eventually be subsumed by the law of averages. A less literal interpretation of the EMH allows for the broad efficiency of the market, but certain assumptions make it possible to exploit advantages.

  Like Dreman, Miller has always adhered to the value approach to investing. He, too, points to Benjamin Graham as an early influence. But Miller goes beyond the P/E ratio. While the P/E ratio is derived from the current price and most recent earnings, Miller says that the more important metric is future earnings. This is where Miller goes beyond Graham. “The only reasonable way to compare [companies] is between the returns you expect to earn from them.” To do that, you have to look to the future, not the past. It is for precisely this reason that Miller was heavily invested in Google, which, even at the time he bought it, had a P/E ratio of 50. To Miller, the distinction between value and growth investing is arbitrary. “Growth is an input to the calculation of value.”8

  Unlike Dreman, however, Miller does not believe in the utility of simple-minded stock screening based on P/E ratios and the like. He doesn’t believe they say much about value. Such a screener would pass over Google because it appears overpriced according to past earnings. But many high-P/E stocks are a bargain when viewed from the perspective of future earnings. Again, like all iconoclasts, Miller is often able to maintain a different perception of value. While much of the market focuses on past earnings, he focuses on future earnings.

  The problem, however, is that calculating future earnings is more art than science, something akin to looking into a crystal ball of the future. In contrast, P/E ratios are computed from known quantities and events that have already happened, and consequently there is no uncertainty about the actual P/E figure. P/E ratios are comforting. Computing a valuation based on the future involves quite a lot more due diligence into what a company is planning and a bit of prognostication as well. But the real issue with estimating future value, as Miller does, is the uncertainty inherent to the process. The future will always be unknowable to a degree, and it is the fear of this uncertainty that prevents many, if not most, investors from using this method. Like the other iconoclasts, Miller does not let the fear of the unknown cloud his perception of value.

  The Biology of the Fear of Failure

  If fear of the unknown prevents most people from taking chances, you can sure bet the fear of failure does too. Any activity in which there is a possibility of failure is, by definition, risky, and it is this fear of failure that makes so many people risk averse. Like the fear of uncertainty and the fear of public ridicule, the fear of failure wends it way through the brain, distorting perception and inhibiting action. Thanks to several recent experiments, we are now beginning to figure out how this happens.

  Although no experiment has directly examined the question of what is inside an iconoclast’s brain, there are studies that have identified neural links between brain differences and behaviors such as risk taking and fear avoidance. The ability to deal with bad news and maintain one’s perception, as we have seen, is a key attribute of the successful iconoclast. Dreman did not change his perception of stock valuation during the Internet bubble. And although he suffered through the loss of clients, he didn’t panic. Similarly, Miller did not change his perception of value according to commonsense, if simplistic, judgments based on P/E ratios. It seems obvious that there should be something different in the brains of people like Dreman and Miller, but because these individuals are rare, it is difficult to pin down what these differences might be. In 2005, my research group found one such difference in the brains of people who reacted strongly to potentially negative information, which has direct implications for the iconoclastic brain.

  While many of the early researchers in neuroeconomics focused on the brain’s response to financial incentives, my group turned to the equally important dark side of decision making: loss. And where loss looms, fear follows. Every decision that a person makes involves a weighing of upsides and downsides. Some people focus entirely on the possibility of a good outcome, while others fixate on the negative. Sound decision making walks a fine line between these two extremes. From a scientific point of view, it has been surprisingly difficult to study the fear of loss on decision making. Nobody will volunteer for an experiment in which they could lose money. Moreover, ethical rules govern
ing human experimentation prohibit experiments in which volunteers have to pay to participate.

  For these reasons, we designed an experiment to examine the effect of a potentially painful outcome on decision making. Understanding how the brain processes pain is of great medical importance, but pain is also crucial to deciphering the iconoclastic brain. Iconoclasts go against the herd. So like Martin Luther King Jr. and others, they inevitably will suffer at some point from fear and the pain of social isolation, if not outright hostility. For most people, the fear of pain or loss is enough to deter them from action.

  The experiment went like this.9 The volunteer was told that the experiment was designed to understand how the brain processes pain. But there was more to it than that. In actuality, we were really interested in the brain’s response to the anticipation of pain. Because unpleasant and potentially painful outcomes in life are unavoidable, how people deal with the anticipation is critical for understanding the decision-making process that distinguishes successful iconoclasts from those who simply give in to their fears. We used the prospect of physical pain in this experiment because it is scientifically expedient to deliver and controllable. The subject was shown an electrical stimulating device that is commonly used in studies of nerve function. In our experiment, however, the electrodes were attached to the top of the subject’s left foot. Through these electrodes, we sent very brief electrical shocks. Although not unbearably painful, the shocks were designed to be unpleasant enough that the individual would prefer to avoid them altogether. The kicker was that they had to wait for the shocks. Every trial began with a statement of how big a shock they were going to receive and how long they had to wait for it, which ranged from one second to almost thirty seconds. For many people, the waiting was worse than the shock. How bad was it? Given a choice, almost every individual preferred to expedite the shock and not wait for it. Nearly a third of the people feared waiting so much that when given the chance, they preferred to receive a bigger shock sooner rather than waiting for a smaller shock later. This was exactly the type of impulsive behavior that we were interested in and that gets in the way of sound financial decision making. We dubbed them “extreme dreaders.”