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In short, we are doomed

In short, we are doomed
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First Published: Mon, May 04 2009. 10 28 PM IST
Updated: Mon, May 04 2009. 10 28 PM IST
John Hussman, of the eponymous Hussman Funds, wrote in his weekly market comment dated 27 April: “If one thing is clear from the last decade, it is that investors have no concern about the ultimate cost of the wreckage as long as they can get a rally going over the short run.” In other words, they ignore long-term risks and focus on short-term rewards. Jason Zweig, the author of Your Money & Your Brain, would not have been surprised.
Our brains have, more or less, stopped evolving after the Stone Age, and most of its instincts were honed in the days when we were just hunter-gatherers. Life expectancy was short. Danger lurked around every corner. Resources were in short supply or had not been discovered. Hence, skills that provided for the day and that helped the species ward off attacks and survive were most needed.
To succeed in investing, investors need less of these and more of analytical and problem-solving skills. In other words, reflection is more important than reflexes. But it is our reflexes that both come to our rescue when we are in danger in normal circumstances and push us into danger and follies when it comes to investing.
Normal people are not only overconfident, but also overconfident of their ability to overcome overconfidence, see patterns where none exists, are quick to bet on a pattern seemingly similar to the one that had helped win rewards in the past and believe, post facto, that they predicted it once they observe an obvious outcome.
Research has demonstrated that “if rats and pigeons knew what a stock market is, they might be better investors than human beings because they seem to be able to stick within the limits of their ability to identify patterns, giving them a natural humility in the face of random events”. Also, epileptic patients judged patterns—or the lack of them—better when they used the damaged portions of their brains.
Our readiness to inflate our predictive power on the basis of observed outcomes in a way explains our readiness to take profits and reluctance to get out of loss-making investments. The former evokes pride and the latter induces regret. Automatically, the brain instructs us to engage in actions that raise our self-worth and avoid those that induce regret. Consequently, most investment portfolios end up with more than their fair share of dead wood.
The late psychologist Amos Tversky says that it would have been wonderful to be a species that had an infinite capacity to experience pleasure and be insensitive to pain. But that would have made human beings losers in the evolutionary battle.
Even as we rely on the reflexive parts of the brain, we seem to have lost some sound reflexes, such as being on guard in the face of uncertainty. Investor behaviour in the last six weeks in chasing up stocks of practically bankrupt financial institutions and markets rife with political uncertainty confirm the finding that the brain scans of those who think they are about to make money and a cocaine addict are indistinguishable.
That is why coming up with rational or reasonable rules for investing is such a seemingly contradictory and confusing exercise. We should be wary of falling too much for the familiar and yet be diligent enough to probe the unknown deeply. We should not follow the herd no matter how painful it is to deviate from the crowd, yet we should not expect to beat the wisdom of the crowd. We should not hesitate to cut losses but we should remember not to sell in a panic when the stock price is falling steeply and well below our purchase price. We should evaluate the investment merits of our holdings each time we decide to add to, or reduce, them, yet put our portfolios on automatic—once or twice a year, automatic rebalancing is desirable.
If it is confusing, then remember that in the investment world, the only sure thing is that there are no sure things, just as change is the only constant in life. Each decision-situation is unique and has a different set of factors to be considered. No wonder that every investment professional eventually meets with his comeuppance.
Given that stock markets would not merit more than 4 inches of space from the end if all of human history were inscribed on a scroll a mile long, it is not a surprise that the brain has not evolved to discern long-term trends, to distinguish random from systematic outcomes and focus on a multitude of factors at once. Maybe, we would get it given sufficient time.
However, it is sobering to note that even the publishers of Your Money & Your Brain don’t seem to have got it. They tempt you to buy the book touting “How the new science of neuroeconomics can help make you rich”.
V. Anantha Nageswaran is chief investment officer for an international wealth manager. These are his personal views. Your comments are welcome at baretalk@livemint.com
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First Published: Mon, May 04 2009. 10 28 PM IST