Investors are hard-wired to fail
The problem is that the human brain was shaped in the Pleistocene era, back when humans had to forage for food. Besides sabotaging our investing instincts, that fact also contributes to obesity, drug addiction and poverty.
At least that's the theory Terry Burnham, a former economist at Harvard who applies biology to the financial markets. A former Marine tank driver who interned at Goldman Sachs, Burnham has traveled the globe in formulating his lizard brain theory, as he calls that ancient, unconscious part of the human brain. (Burnham has traveled, for example, to Uganda to study wild chimpanzees and to the boardroom to study the role of testosterone in negotiations.) His new book, Mean Markets and Lizard Brains: How to Profit from the New Science of Irrationality, uses everyday language and examples from popular culture (if you aren't an ardent moviegoer, his many movie references may leave you puzzled) to help investors understand how their mental processes can cause costly mistakes.
In the early 1990s, Burnham co-founded Progenics Pharmaceuticals, which now trades on the Nasdaq. He holds a doctorate in business economics from Harvard and a master's in finance from MIT. He co-authored Mean Genes, From Sex to Money to Food: Taming Our Primal Instincts with Jay Phalen; it's a Darwinian tract explaining, among other things, why we like junk food more than fruit and why we are so prone to go into debt. The answer? It's in our genes.
To help control his “lizard brain,” Burnham has a full-service broker who charges commissions.
Registered Rep.: Mean Markets and Lizard Brains is an unusual title for a book about finance. Perhaps you could start by defining lizard brains.
Terry Burnham: The basic notion, which goes all the way back to Plato, is that there's a war going on inside our brains. In recent years, the rational and the emotional parts of the brain have been identified through neuro-imaging. The front part above your eyes is where analytical calculations go on, and the back of the brain is where the more ancient structures of the brain are. We can put people in MRI scanners and see the back of the brain light up and push them down the path towards bad decisions.
So I use the phrase “the lizard brain” to refer to all back-of-the-brain activity. Lizard brain is the part of the brain that's making you do stuff that you're not aware of. It sounds like a non-academic term; it sounds almost flippant. Yet when I talk to people they know what I mean right away, they understand that there's an animalistic part of human nature that influences behavior.
RR: Yet this primitive brain contributes to survival.
TB: There are a lot of areas where your instinctual approach can be good. When you meet people and you feel uneasy about them, it might be wise to heed that signal. With financial markets, you have to shackle the lizard brain if you want to make wise decisions.
RR: You tantalize the reader by writing that there are $100 bills laying on the sidewalk, but we miss them because they're hidden in the blind spots of our lizard brains. You even say that this part of our brains is pushing us to do the opposite of what is in our best interests.
TB: Some professors studied the trading records of 10,000 investors at a discount brokerage, investors who made quick decisions to sell one stock and buy another. The study compares the performance of the stocks they sold with the ones they bought. Over a year's time, the ones they had sold did better than the ones they bought by 300 basis points, which is the difference between caviar and cat food. When people trade with their emotions they do exactly the wrong thing.
RR: Although you confess to having engaged in short-term trading, your message is trade as little as possible.
TB: Trade as little as possible and as unemotionally as possible. In another study, MIT professors hooked up professional traders to something like a stress test, which would measure skin temperature and various different reactions. All of the traders had measurable emotional responses to breaking news. But the more experienced ones had weaker emotional responses to news than the less experienced traders.
RR: You explain a tendency of the primitive brain to extrapolate from the past and to find patterns.
TB: In worlds where humans spent a long time hunting and dealing with nature — animals, plants, and so forth — very often the past is the best predictor of the future. The brain is built to find patterns. We know from studies that if you flip a coin in front of a person, the more times heads comes up, the more surprised part of the brain is when it's tails. Although the coin toss is fair and the person knows that, their lizard brain is saying, “Well, he's flipped it 10 times, it's come up heads eight times — maybe it's more likely to come up heads.” So when it finally comes up tails, that part of the brain says, “Oh, whoa. We were expecting heads.” This is destructive if applied naively to financial markets. If you believe a certain stock or industry is going to go up this year because it went up last year, you may be disappointed.
RR: What about technical analysis, which relies on patterns of past performance?
TB: I think it's certainly possible that people find patterns when there aren't any. But I'm more on the side of the technical analysts because some patterns have a possibility of repeating since that's how the brain works.
Here's a classic scenario: Wal-Mart traded in the $50s for a long time, and now it's in the $40s. The technical analysts' view — the reason that it's supported by the lizard brain — is that there are millions of shares that people remember buying in the $50s, so when the stock price gets up in the $50s, they might say, “Oh, now I'm a winner. I've made back my money, I'll sell it.” This creates a potential for the validity of technical analysis. But you really need to combine both traditional forecasting with the understanding of cycles. I find the combination to be much more powerful than either one individually.
RR: You call this “the meanest of markets” and “kryptonite for the lizard brain.” When you look at the present and the immediate future, you're not at all optimistic.
TB: In each of the three big asset markets — stocks, bonds and real estate — we've been going above our natural speed limit. For example, ever since I've started investing in the early 1980s, interest rates have been going down. So my lizard brain says, “Ah ha! We live in is a world where interest rates go down over time.” But that's not the world we're going to be living in for the next generation
What's true for the bond market is also true for the housing and the stock market. We're set up to be disappointed. This is dangerous time for individual investors. Since our brains are backward looking, we're really in tough shape when powerful trends end.
RR: What advice would you like to pass along to financial advisors?
TB: I'd like for reps to read the book and understand how emotions and past patterns influence their own and other people's choices. The client or the nonprofessional will be helped by having the professional lean into the emotional response.
RR: You have an account with a full-service broker who charges standard commission fees.
TB: Yes. I wanted to slow down my emotional trading and I wanted to involve another person in the process. By talking about investment ideas, you engage the rational part of the brain. If you didn't understand the lizard brain, you'd think, “Why would I pay $100 for something I can get for $5?” The answer is you can't get it for $5. There's no money better spent than what prevents you from making a stupid trade. Anyone can benefit from involving someone else in financial decisions.
My last point — and I like the quote so much I've used it in both books I've written — it's Plato's quote that knowing his own weaknesses was the source of his own strength. The great traders that I've known, Paul Jacobson and Paul Tudor Jones, would joke about how their emotions would push them to do the wrong thing. Admitting that part of your brain is working against you is not a sign of weakness — it's the first step towards really doing well in financial markets. It's a sign of sophistication.