THE GREAT HUMILIATOR III
Posted on Wednesday, January 24, 2007
(exerpt from The Only Three Questions That Count, Ken Fisher, 2007)What The Heck Is My Brain Doing To Blindside Me Now?
It’s Not Your Fault — Blame Evolution
One of the first things we learn about finance is “Buy low, sell high.” In the movie Trading Places, when Eddie Murphy and Dan Akroyd prepare to corner the orange juice market (illegally and implausibly, but comically), you can tell the script wirter was casting about for something finance-sounding to say. So Dan tells Eddie, “Buy low, sell high.” What more advice do you need, really?
We all know the goal, but more often than not we end up doing the opposite. How hard can this be? Buy when stuff is priced low; sell when it’s priced high. It’s not rocket science. And yet, this problem is ageless and endless. Investors routinely buy and sell precisely backwards. For evidence, look at fund flows– the amount of money going into and out of equity mutual funds (unit trusts) each month.
Inflows for stock mutual funds were highest during February 2000. That was about the best time in recent history to get out of stocks– at the peak of the ensuing three-year bear market. Fast forward to 2002, and the reverse is true. Everyone bailed from funds in July– a fantastic time for stocks– just before a new bull market. Here is incontrovertible evidence of investors buying high and selling low en masse. These weren’t a few deranged ignoramuses engaging in this behavior. This shows a widespread group-think– a frenzied mob of loser lemmings lumbering in and out of the market precisely backwards.
No investor intends to buy high and sell low. That would be stupid. So why do so many of us end up doing the stupid? There are many convenient scapegoats. Recently, following 2002, Enron, MCI, and the like, a popular way to skirt responsibility for poor investing decisions was demonizing crooked CEOs. Your stock portfolio would have done fine were it not for every American CEO being a thief and a liar, right? Jeffrey Skilling, Ken Lay, and the rest– all convicted, right? Or, it’s the war in Iraq (Iran, North Korea, Berkeley– whatever socialist or communist or neo-fascist regime we oppose at the time). Or it’s outsourcing. Illegal aliens. Inflation. The savings rate. Natural disasters. Hurricanes! Packs of rabid wild dogs roaming free! Killer bees infected with bird flu! It doesn’t matter.
Stop pointing your finger at everyone else. If you want to know what causes your investments to fare poorly, look in the mirror. Better yet, get a CAT scan done. Your biggest investing enemy is your brain. Even more precisely, your biggest enemy is the cerebral evolution that formed your brain to be largely focused on keeping you alive in the face of starvation, treachery, and wooly fanged beasts.
To survive as a species, our brains evolved with specific goals in mind– primarily bodily survival in a primitive world. The easy ability to buy good food at the local supermarket or bistro and live relatively free from fear of instant death or dismemberment at the claws of predatory beasts is relatively new to human development– an advancement still in its infancy. Humans spent most of their evolution as hunter-gatherers, traveling in nomadic bands, hunting wild animals, foraging for often spoiled foods, finding mates to perpetuate the species (which is a lot more enticing than investing in stocks), avoiding predators, and seeking shelter. These are the tasks our brains evolved for– to keep us fed, warm, dry, and safe from saber-toothed tigers and brown recluse spiders.
Think of our Stone Age ancestors and how their survival struggle impacts how we behave now. Our ancestors’ friends were there tribesmen (and women)– people they could trust. Their enemies were other tribes, rampaging beasts, and the dark things they couldn’t understand. As such, they banded together for protection and lit fires to keep the dark (and the dark things) away. Recall our example of the noise outside the campfire– the same cognitive processes kept our ancestors alive and served them well for tens of thousands of years. We’ve only had a short time when they’ve caused us to make errors and then only in limited realms, largely offset by other more common life realms where they don’t hurt us to this day.
Even with technology and the complexity of modern society, most of this preordained wiring remains intact. Prewiring as a concept is somewhat controversial among psychologists. Evolutionary psychology is sometimes equated with pop-culture thinking by critics. I’ll not attempt to retread the literature on evolutionary psychology here. For an introduction to this area, try How the Mind Works by Steven Pinker of Harvard (Norton, 1997). It covers a lot of turf fast.
But I’m firmly convinced most of our shortcomings in seeing markets correctly stem from cranial handwiring derived from many eons of evolution and are so fixed in our brains we can’t escape them. Because we can’t get people from 25,000 years ago to appear for scrutiny now, we can never prove or disprove much of this. But based on studying what has and hasn’t been proved and what is reasonable to me, I believe if you simply restrict your thinking about psychology to how we think about markets, you will see evolutionary psychology and hardwiring are very basic.
Our brains are so structured that when information comes in a form our brains are hardwired to receive well, we process it correctly, easily, and quickly. When information comes to our brains in a form or framework our brain isn’t hardwired to process well, we are often simply blind to it. And that’s because our brains are hardwired by evolution to take certain types of inputs down defined paths and not elsewhere. You have already seen some of that with the P/E and E/P trade off. (This refers to our sense that a PE of 20 seems high, but the inverse, an earnings yield of 5%, feels rather comfortable). But you see it throughout this book, recurring in phenomenon after phenomenon. While behavioral finance is not based on evolutionary psychology, many discoveries paralleling evolutionary psychology have been uncovered in the past 30 years in behavioral finance.
Behavioral Finance… to be continued…
Credits: This article is extracted, with modifications and additions, from The Only Three Questions That Count by Ken Fisher (Wiley Finance, 2007).
(exerpt from The Only Three Questions That Count, Ken Fisher, 2007)What The Heck Is My Brain Doing To Blindside Me Now?
It’s Not Your Fault — Blame Evolution
One of the first things we learn about finance is “Buy low, sell high.” In the movie Trading Places, when Eddie Murphy and Dan Akroyd prepare to corner the orange juice market (illegally and implausibly, but comically), you can tell the script wirter was casting about for something finance-sounding to say. So Dan tells Eddie, “Buy low, sell high.” What more advice do you need, really?
We all know the goal, but more often than not we end up doing the opposite. How hard can this be? Buy when stuff is priced low; sell when it’s priced high. It’s not rocket science. And yet, this problem is ageless and endless. Investors routinely buy and sell precisely backwards. For evidence, look at fund flows– the amount of money going into and out of equity mutual funds (unit trusts) each month.
Inflows for stock mutual funds were highest during February 2000. That was about the best time in recent history to get out of stocks– at the peak of the ensuing three-year bear market. Fast forward to 2002, and the reverse is true. Everyone bailed from funds in July– a fantastic time for stocks– just before a new bull market. Here is incontrovertible evidence of investors buying high and selling low en masse. These weren’t a few deranged ignoramuses engaging in this behavior. This shows a widespread group-think– a frenzied mob of loser lemmings lumbering in and out of the market precisely backwards.
No investor intends to buy high and sell low. That would be stupid. So why do so many of us end up doing the stupid? There are many convenient scapegoats. Recently, following 2002, Enron, MCI, and the like, a popular way to skirt responsibility for poor investing decisions was demonizing crooked CEOs. Your stock portfolio would have done fine were it not for every American CEO being a thief and a liar, right? Jeffrey Skilling, Ken Lay, and the rest– all convicted, right? Or, it’s the war in Iraq (Iran, North Korea, Berkeley– whatever socialist or communist or neo-fascist regime we oppose at the time). Or it’s outsourcing. Illegal aliens. Inflation. The savings rate. Natural disasters. Hurricanes! Packs of rabid wild dogs roaming free! Killer bees infected with bird flu! It doesn’t matter.
Stop pointing your finger at everyone else. If you want to know what causes your investments to fare poorly, look in the mirror. Better yet, get a CAT scan done. Your biggest investing enemy is your brain. Even more precisely, your biggest enemy is the cerebral evolution that formed your brain to be largely focused on keeping you alive in the face of starvation, treachery, and wooly fanged beasts.
To survive as a species, our brains evolved with specific goals in mind– primarily bodily survival in a primitive world. The easy ability to buy good food at the local supermarket or bistro and live relatively free from fear of instant death or dismemberment at the claws of predatory beasts is relatively new to human development– an advancement still in its infancy. Humans spent most of their evolution as hunter-gatherers, traveling in nomadic bands, hunting wild animals, foraging for often spoiled foods, finding mates to perpetuate the species (which is a lot more enticing than investing in stocks), avoiding predators, and seeking shelter. These are the tasks our brains evolved for– to keep us fed, warm, dry, and safe from saber-toothed tigers and brown recluse spiders.
Think of our Stone Age ancestors and how their survival struggle impacts how we behave now. Our ancestors’ friends were there tribesmen (and women)– people they could trust. Their enemies were other tribes, rampaging beasts, and the dark things they couldn’t understand. As such, they banded together for protection and lit fires to keep the dark (and the dark things) away. Recall our example of the noise outside the campfire– the same cognitive processes kept our ancestors alive and served them well for tens of thousands of years. We’ve only had a short time when they’ve caused us to make errors and then only in limited realms, largely offset by other more common life realms where they don’t hurt us to this day.
Even with technology and the complexity of modern society, most of this preordained wiring remains intact. Prewiring as a concept is somewhat controversial among psychologists. Evolutionary psychology is sometimes equated with pop-culture thinking by critics. I’ll not attempt to retread the literature on evolutionary psychology here. For an introduction to this area, try How the Mind Works by Steven Pinker of Harvard (Norton, 1997). It covers a lot of turf fast.
But I’m firmly convinced most of our shortcomings in seeing markets correctly stem from cranial handwiring derived from many eons of evolution and are so fixed in our brains we can’t escape them. Because we can’t get people from 25,000 years ago to appear for scrutiny now, we can never prove or disprove much of this. But based on studying what has and hasn’t been proved and what is reasonable to me, I believe if you simply restrict your thinking about psychology to how we think about markets, you will see evolutionary psychology and hardwiring are very basic.
Our brains are so structured that when information comes in a form our brains are hardwired to receive well, we process it correctly, easily, and quickly. When information comes to our brains in a form or framework our brain isn’t hardwired to process well, we are often simply blind to it. And that’s because our brains are hardwired by evolution to take certain types of inputs down defined paths and not elsewhere. You have already seen some of that with the P/E and E/P trade off. (This refers to our sense that a PE of 20 seems high, but the inverse, an earnings yield of 5%, feels rather comfortable). But you see it throughout this book, recurring in phenomenon after phenomenon. While behavioral finance is not based on evolutionary psychology, many discoveries paralleling evolutionary psychology have been uncovered in the past 30 years in behavioral finance.
Behavioral Finance… to be continued…
Credits: This article is extracted, with modifications and additions, from The Only Three Questions That Count by Ken Fisher (Wiley Finance, 2007).
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