Your Money & Your Brain

In the July/August 2008 issue,
Journal of Indexes: Money and Your Mind

[The following is an excerpt from Jason Zweig’s recent book, Your Money & Your Brain: How the New Science of Neuroeconomics Can Help Make You Rich, Simon & Schuster, August 1, 2007.]

– I’ve taken a few excerpts, go here to read the full reprint. – Ilene

Pecuniary motives either do not act at all—or are of that class of stimulants which act only as Narcotics. —Samuel Taylor Coleridge

From Babel To Bubble

In the Mesopotamian galleries of the British Museum in London sits one of the most startling relics of the ancient world: a life-size clay model of a sheep’s liver, which served as a training tool for a specialized Babylonian priest known as a baru, who made predictions about the future by studying the guts of a freshly slaughtered sheep. The model is a catalog of the blemishes, colors, and differences in size or shape that a real sheep’s liver might display. The baru and his followers believed that each of these variables could help foretell what was about to happen, so the clay model is painstakingly subdivided into sixty-three areas, each marked with cuneiform writing and other symbols describing its predictive powers.

What makes this artifact so astounding is that it is as contemporary as today’s coverage of the financial news. More than 3,700 years after this clay model was first baked in Mesopotamia, the liver-reading Babylonian barus are still with us—except now they are called market strategists, financial analysts, and investment experts. The latest unemployment report is ”a clear sign” that interest rates will rise. This month’s news about inflation means it’s ”a sure thing” that the stock market will go down. This new product or that new boss is ”a good omen” for a company’s stock.

Just like an ancient baru massaging the meanings out of a bloody liver, today’s market forecasters sometimes get the future right—if only by luck alone. But when the ”experts” are wrong, as they are about as often as a flipped coin comes up tails, their forecasts read like a roster of folly:

Every December, BusinessWeek surveys Wall Street’s leading strategies, asking where stocks are headed in the year to come. Over the past decade, the consensus of these ”expert” forecasts has been off by an average of 16 percent.
On Friday the 13th in August 1982, the Wall Street Journal and the New York Times quoted one analyst and trader after another, all spewing gloom and doom: ”A selling climax will be required to end the bear market,” ”investors are on the horns of a dilemma,” the market is gripped by ”outright capitulation and panic selling.” That very day, the greatest bull market in a generation began—and most ”experts” remained stubbornly bearish until the rebound was long under way.
On April 14, 2000, the NASDAQ stock market fell 9.7 percent to close at 3321.29. ”This is the greatest opportunity for individual investors in a long time,” declared Robert Froelich of Kemper Funds, while Thomas Galvin of Donaldson, Lufkin & Jenrette insisted ”there’s only 200 or 300 points of downside for the NASDAQ and 2000 on the upside.” It turned out there were no points on the upside and more than 2,200 on the downside, as NASDAQ shriveled all the way to 1114.11 in October 2002.
In January 1980, with gold at a record $850 per ounce, U.S. Treasury Secretary G. William Miller declared: ”At the moment, it doesn’t seem an appropriate time to sell our gold.” The next day, the price of gold fell 17 percent. Over the coming five years gold lost two-thirds of its value.
Even the Wall Street analysts who carefully study a handful of stocks might as well be playing ”eeny meeny miny moe.” According to money manager David Dreman, over the past thirty years, the analysts’ estimate of what companies would earn in the next quarter has been wrong by an average of 41 percent. Imagine that the TV weatherman said it would be 60 degrees yesterday, and it turned out to be 35 degrees instead—also a 41 percent error (on the Fahrenheit scale). Now imagine that’s about as accurate as he ever gets. Would you keep listening to his forecasts?

All these predictions fall prey to the same two problems: First, they assume that whatever has been happening is the only thing that could have happened. Second, they rely too heavily on the short-term past to forecast the long-term future, a mistake that the investment sage Peter Bernstein calls ”postcasting.” In short, the ”experts” couldn’t hit the broad side of a barn with a shotgun—even if they stood inside the barn.

As a matter of fact, whichever economic variable you look at—interest rates, inflation, economic growth, oil prices, unemployment, the Federal budget deficit, the value of the U.S. dollar or other currencies—you can be sure of three things: First, someone gets paid lots of money to make predictions about it. Second, he will not tell you, and may not even know, how accurate his forecasts have been over time. Third, if you invest on the basis of those forecasts, you are likely to be sorry, since they are no better a guide to the future than the mutterings of a Babylonian baru.

The futility of financial prediction is especially frustrating because it seems so clear that analysis should work. After all, we all know that studying beforehand is a good way to improve our (or our children’s) test scores. And the more you practice your golf or basketball or tennis shot, the better player you will become. Why should investing be any different? There are three main reasons why investors who do the most homework do not necessarily earn the highest grades:

How We Got Our Brains

Why are we cursed with this blessing—or blessed with this curse—of compulsively seeking patterns in random data? ”It’s a really weird thing,” exclaims Paul Glimcher, a neurobiologist at New York University’s Center for Neural Science. ”I hang out with my economist friends, and they analyze financial decision making as if it were a Platonic problem in reasoning. They don’t have a clue that it’s a biological problem. We’ve got millions of years of primate evolution behind us. We are biological organisms. Of course there’s something biological going on! Evolution must drive the decisions we make when we face the kinds of situations we evolved to encounter.” (emphasis mine, I liked that.)

For nearly our entire history as a species, humans were hunter-gatherers, living in small nomadic bands, seeking mates, finding shelter, pursuing prey and avoiding predators, foraging for edible fruits, seeds, and roots. For our earliest ancestors, decisions were fewer and less complex: Avoid the places where leopards lurk. Learn the hints of coming rainfall, the clues of antelope just over the horizon, the signs of fresh water nearby.

Understand who is trustworthy, figure out how to collaborate with them, learn how to outsmart those who are not. Those are the kinds of tasks our brains evolved to perform.

”The main difference between us and apes,” explains anthropologist Todd Preuss of Emory University, ”seems to be less a matter of adding new areas [in the brain], and more a matter of enlarging existing areas and modifying their internal machinery to do new and different things. The ‘what if’ questions, the ‘what will happen when’ questions, the short-term and long-term consequences of doing X or Y—we have lots more of the brain where that kind of processing goes on.” Humans are not the only animals that make tools, show insight, or plan for the future. But no other species can match our phenomenal ability to forecast and extrapolate, to observe correlations, to infer cause from effect.

Our own advanced species, Homo sapiens sapiens, is less than 200,000 years old. And the human brain has barely grown since then; in 1997, paleoanthropologists discovered a 154,000-year-old Homo sapiens skull in Ethiopia. The brain it once held would have been about 1,450 cubic centimeters in volume. That is at least three times the volume of a gorilla or chimpanzee brain—but no smaller than the brain of the average person living today. Our brains are deeply rooted in the primeval environments in which our earlier ancestors evolved, long before Homo sapiens arose. Evolution has not stopped, but most of the ”modern” areas of the human brain, like the prefrontal cortex, developed largely during the Stone Age.

It’s easy to visualize the ancient East African plain: a highly variable and camouflaged environment, with alternating dapples of sun and shade, patches of dense foliage, and rolling open ground broken by sharply banked streambeds. In that landscape, extrapolation—figuring out the next link that would complete a simple pattern of repeating visual cues—became a vital adaptation for survival. Once a sample of information yielded the correct answer (ample food, safe shelter), it would never have occurred to the early hominids to look for more proof that they had made the right decision. So our ancestors learned to make the most of small samples of data, and our investing brains today still specialize in this kind of ”I get it” behavior: perceiving patterns everywhere, leaping to conclusions from fragmentary evidence, overrelying on the short run when we plan for the long-term future.

We like to imagine that a long history of technological advancement stands behind us, but domesticated food crops and the first cities date back only about 11,000 years. The earliest known financial markets—in which products like barley, wheat, millet, chickpeas, and silver were sporadically traded—sprang up in Mesopotamia around 2500 B.C. And formal markets with regular trading of stocks and bonds date back only about four centuries. It took our ancestors more than 6 million years to progress to that point; if you imagine all of hominid history inscribed on a scroll one mile long, the first stock exchange would not show up until four inches from the end.

No wonder our ancient brains find the modern challenges of investing so hard to manage. The human mind is a high-performance machine—”a Maserati,” says Baylor College of Medicine neuroscientist P. Read Montague—when it comes to solving prehistoric problems like recognizing simple patterns or generating emotional responses with lightning speed. But it’s not so good at discerning long-term trends, recognizing when outcomes are truly random, or focusing on a multitude of factors at once—challenges that our early ancestors rarely faced but that your investing brain confronts every time you log on to a financial Web site, watch CNBC, talk to a financial advisor, or open the Wall Street Journal.

Why Do You Think They Call It Dopamine?

Wolfram Schultz, a neurophysiologist at the University of Cambridge in England, has closely cropped grey hair and a neatly trimmed silver mustache. He is so fastidious that he turns his office teacups upside down on a towel when he’s not using them, lest they get dusty. The day I visited him, the only notable decoration in his office was a poster of the Rosetta Stone, a reminder of how enormous a task neuroscientists face as they try to drill down to the biological bedrock of how we make decisions. A German who spent years teaching in Switzerland, Schultz seems tailor-made to explore the microstructure of the brain by monitoring the electrochemical activity of one neuron at a time.

Schultz specializes in studying dopamine, a chemical in the brain that helps animals, including humans, figure out how to take actions that will result in rewards at the right time. Dopamine signals originate deep in the underbelly of the brain, where your cerebral machinery connects to your spinal cord. Of the brain’s roughly 100 billion neurons, well under one-thousandth of 1 percent produce dopamine. But this minuscule neural minority wields enormous power over your investing decisions.

”Dopamine spreads its fingers all over the brain,” as neuroscientist Antoine Bechara of the University of Southern California describes it. When the dopamine neurons light up, they don’t focus their signals as if they were flashlights aiming at isolated targets; instead, these neural connections shoot forth their bursts like fireworks, sending vast sprays of energy throughout the parts of the brain that turn motivations into decisions and decisions into actions. It can take as little as a twentieth of a second for these electrochemical pulses to blast their way up from the base of your brain to your decision centers.

In the popular mind, dopamine is a pleasure drug that gives you a natural high, an internal Dr. Feelgood flooding your brain with a soft euphoria whenever you get something you want. There’s more to it than that. Besides estimating the value of an expected reward, you also need to propel yourself into the actions that will capture it. ”If you know that a reward might happen,” says psychologist Kent Berridge of the University of Michigan, ”then you have knowledge. If you find that you can’t just sit there, but that you must do something, then that’s adding power and motivational value to knowledge. We’ve evolved to be that way, because passively knowing about the future is not good enough.”…