Illusory Patterns

Some people’s investment results would improve from targeted brain damage.

This rather shocking statement is based on an article Jason Zweig wrote in the Wall Street Journal, “Why We’re Driven to Trade.” Neuroscience research has shown that specific parts of the brain contribute to certain decision making. More narrowly, researchers have found that one part of the brain, the frontopolar cortex, contributes to predicting rewards.

To better understand such decision making, researchers set up an experiment with three groups: two groups without brain damage and one group with damage to their frontopolar cortex. Then, they let the three groups play a series of games where the rewards varied unpredictably. 

What they found was that the two groups without brain damage tended to base their decisions on very recent data–their last two games played–whereas the group with brain damage tended to base their decisions on cumulative data of all the games they’d played. The more effective approach is to use cumulative instead of recent data.

Basically, the frontopolar cortex is a part of the brain that’s used to recognize patterns. It works great when there are useful patterns to be recognized, but when no patterns exist (as they don’t with random data) it goes right on recognizing illusory patterns that aren’t really there. 

The result is that when we run into rewards with unpredictable variability, our brains still tend to react as if it finding patterns (even though there are none). That’s why people with a damaged frontopolar cortex have an advantage in dealing with such circumstances: they don’t have a part of the brain that would recognize and act on illusory patterns.

This research holds lessons for investors, because investment returns–and you may have guessed this–vary unpredictably just like the game in the experiment. Like the two groups without brain damage, most people base their investing decisions on recent instead of cumulative results. This leads them to trade too frequently, selling something that has done poorly recently and buying something that has done well recently only to find what they bought does poorly and what they sold does well.

The good news is that you don’t need to damage your brain to invest better. Investors who base their decisions on long term, cumulative results instead of recent data can do just as well as those with a damaged frontopolar cortex. 

First, don’t buy just because a stock goes up or sell because a stock goes down. That’s basing your decision on recent data. Second, use long term, cumulative data to make decisions instead of short term, recent data. Third, make sure you have three reasons, outside of stock price movements, for deciding to buy or sell. And, last, keep track of your results so you can generate a cumulative record of what does and doesn’t work. This is best done by keeping track of what you sell as well as what you buy.

You don’t need brain damage to do better, you just need to create a deliberate decision making process that does an end-run around the part of your brain that sees illusory patterns. 

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

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Illusory Patterns

Optimism = poor returns

It’s easiest to invest when you feel good about a company or the economy. That feeling reflects good recent results, and a herd of other people who share your good impression. Good feelings cause people to push prices far above underlying value. When the future turns out to be not as rosy as people’s inflated expectations, prices move back to value and poor returns result.

Exhibit A is 1999, when almost everyone was so optimistic about technology stocks, right before they dropped 76%.

Exhibit B is 2006, when almost everyone was in love with the real estate market, right before it plunged over 30%.

It’s hardest to invest when you feel terrible about a company or the economy. That bad feeling is due to poor recent results, and a herd of other people who agree that prospects are lousy. Bad feelings cause people to sell or not buy, pushing prices far below underlying value. When the future turns out to be not as bleak as most expect, prices move back up to value and better than average returns ensue.

Exhibit C is 2003, after the stock market dropped 48% and the second Gulf War started, right as the market started to climb 95% over the next 4 1/2 years.

Exhibit D is 2009, after the stock market dropped 56% and there were rumors the government was going to nationalize the banks, right as the market started to climb 106% over the following 3 years.

My point: optimism leads to poor returns, and pessimism precedes great returns.

The above is easier to grasp than it is to follow. Most people know they should buy low and sell high, but they mistakenly believe that they should wait “until the coast is clear” to invest, and run for cover “when the future looks scary.” They know what they should do, but they succumb to optimism or pessimism and don’t act.

Warren Buffett is the most successful investor alive because he is “greedy when others are fearful and fearful when others are greedy.” Follow his lead:

  • If the coast is clear and it looks like everything is coming up roses, that’s not the time to double down–expect poor future returns
  • If some people are optimistic and others pessimistic, then you can expect average returns
  • If people are panicking and running for cover, that’s the time to double down–expect high future returns

In other words, don’t expect great results if everything looks safe, and don’t expect poor results just because everything looks gloomy. 

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Optimism = poor returns

A little perspective

If you ever want an experiment in what’s important, try packing everything you value into two cars with danger at your heels.

I live in the foothills the Rocky Mountains, in Colorado Springs, Colorado. Because of the Waldo Canyon fire, we had to evacuate our home on Tuesday, June 26th.  The fire started on the 23rd, so we had over 3 days to prepare–plenty of time. And yet, it seemed like a somewhat theoretical effort until smoke covered our neighborhood, a bizarre yellow light shown on everything, and ashes were literally falling from the sky.

In hindsight, firefighters stopped the fire 1.8 miles from my home, and 0.6 miles from my in-laws’ home. What seemed theoretical and just-in-case at first became starkly real on Tuesday evening when we went from voluntary to mandatory evacuation in about 20 minutes (not including the delay in receiving that information–yikes!).

First: bring what can’t be replaced.  Wife, check; daughter, check; cat, check; fish, can’t really transport on short notice. Also, bring photo’s that aren’t digitally backed-up (something to look into…), paperwork like marriage and birth certificates, passports, wills and life insurance documents, business paperwork, computers, other records, memorabilia, heirlooms, old daily planners, etc . If you’re a nerd–I am–bring underlined books (the others can be replaced, but the underlining can’t).  

Second: bring stuff you’ll need to get by for a couple of days like clothes, food and water, sleeping bags and thermarests, so you can sleep anywhere. Be prepared to find out that all hotels are booked and you may need to find someplace else to stay (in a town of 500,000, there aren’t 30,000+ hotel rooms, of course).

Third, other people can be amazingly helpful. My father-in-law owns a commercial building with a vacancy, so we had a place to crash that first night. We went to eat at Old Chicago’s, and the manager gave us our meal and drinks for free after he found out we had been evacuated (talk about a brilliant loyalty program). Before we even asked, we had 4 offers of places to stay in Colorado Springs, and 3 in Denver. After one night in the commercial building, my mother-in-law’s tennis friend, and her husband, gave us their home in Monument, CO while they went on a trip to Chicago to see family. We spent 3 nights there before returning to our home last Saturday (no damage whatsoever–thanks to the firefighters).

Fourth, everyone has a job to do, and I’m endlessly fascinated by the professionalism of people who do good work. From the beginning of the fire through today, I’ve been watching the intelligence, tireless efforts, and efficacy of firefighters, emergency-responders, police, utility operators, etc. This has been truly inspiring.

I’ve watched firefighters from the forest and city brief us twice daily, and this has given me a new appreciation and vocabulary (point protection, anchor, dozer line) to describe wildfires and how to fight them. Rich Harvey is the man.

I’ve also watched aircrews (helicopters and fixed wing) and firefighters fight the fire day and night for the last week and a half. They’ve had amazing victories (the fire is 55% contained at present), and terrible defeats (346 homes destroyed, 2 lives lost). It could have been much worse if it weren’t for the firefighters’ dedication and efficacy, but the outcome is still awful nonetheless.

All told, I have a new appreciation for what I own, what’s truly irreplaceable, the wonderful people I know, and for the people I don’t know, but can truly respect and admire from afar.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

A little perspective