THE PREHISTORIC INVESTOR I
POSTED :02 May 2005
THE PREHISTORIC INVESTOR I
How The Mind Works
After an event occurs just two or three times in a row, regions of the human brain called the anterior cigulated and nucleus accumbens automatically anticipate that it will happen again. If it does repeat, a natural chemical called dopamine is released, flooding your brain with a soft euphoria. Thus, if a stock goes up a few times in a row, you reflexively expect it to keep going--and your brain chemistry changes as the stock rises, giving you a natural high. You effectively become addicted to your own predictions.
-- Jason Zweig
The mind has to be built out of specialized parts because it has to solve specialized problems. Only an angel could be a general problem-solver; we mortals have to make fallible guesses from fragmentary information. Each of our modules solves its unsolvable problem by a leap of faith about how the world works, by making assumptions that are indispensable but indefensible--the only defense being that the assumptions worked well enough in the world of our ancestors.
-- Steven Pinker
Human Instincts
Investors are humans, so investor psychology is all about human psychology, which is directly related to understanding how the human brain/mind works. To understand our instincts and behaviors we need to gain a historical perspective on the evolution of our modern species from more ancestral predecessors. Our human brain, after all, is very close in design to that of our closest relatives, such as the chimpanzee--but, as Steven Pinker notes, the human brain is far more accomplished.
We are naked, lopsided apes that speak, but we also have minds that differ considerably from those of apes. The outsized brain of Homo sapiens sapiens is, by any standard, an extraordinary adaptation. It has allowed us to inhabit every ecosystem on earth, reshaped the planet, walk on the moon, and discover the secrets of the physical universe. Chimpanzees, for all their vaunted intelligence, are a threatened species clinging to a few patches of forest and living as they did millions of years ago.
Yet despite the admirable accomplishments of man, especially in the fields of science and industry, we struggle clumsily when it comes to making intelligent investment decisions. How can that be? It would seem immensely simpler to build a high-return stock portfolio than to build a space shuttle, after all. But struggle we do when it comes to stock market investments, and the major reason is that we have inherited a set of powerful instincts from our ancestors that are maladapted to modern financial markets.
Why are ancient instincts so powerful? You must consider that modern man began to evolve from earlier great apes in Africa about 5-7 million years ago, and only about 13,000 years ago did our Homo sapiens ancestors succeed in populating all major landmasses. So, what we consider modern times, or 'historic' times (as opposed to 'prehistoric times')--man living in large communities with organized oral and written language, specialized careers, commerce and trade and such--is, on an evolutionary time scale, just the blink of an eye. So, after evolving a set of instincts and behaviors that were nurtured by the forces of natural selection over thousands and thousands of generations, we were all of a sudden thrown into a modern environment that in many ways we are not well adapted to. Let's look at some examples of our poorly adapted state as it relates to the field of investment.
Pattern Biases
When our most ancient ancestors first learned that pattern recognition in nature could offer predictive value, they had happened upon a distinct competitive advantage. Day followed night, the moon appeared after sunset, cold seasons were followed by warm seasons; wet seasons were followed by dry seasons, etc. Being able to predict the future based on assuming observed patterns would be repeated perpetually allowed our ancestors to be prepared for expected changes, whether it meant storing some extra food and water or building a shelter.
Unfortunately, not all observed sequences have patterns that repeat. Nonetheless, when there are not patterns, we instinctively invent them, and also instinctively use imaginary patterns to predict the future (see chart readers or technical analysts).
Memory Modifications
We think our memories are much more accurate then they really are. I first learned this surprising fact when reading The Best American Science And Nature Writings 2003, which included a reprint of an article from Issues in Science and Technology called 'Memory Faults and Fixes' by Elizabeth F. Loftus.
Loftus began the article by suggesting courts of law change their swearing in statement to, 'Do you swear to tell the truth, the whole truth, or whatever it is you think you remember?' She noted that year 2003 saw the release of the hundredth person from U.S. prisons that had been convicted on the basis of eyewitness testimony and later (sometimes many years later) freed on the basis of genetic evidence testing.
Loftus documents that a variety of psychological studies have shown that it is vurtually impossible to tell the difference between a real memory and one that is a product of imagination or some other process. It turns out that memories are not fixed but remain modifiable or malleable in our minds. Our memories are vulnerable to 'post-event information': to details, ideas, and suggestions that come along after an event has happened. People integrate new materials into their memory, modifying what they believe they personally experienced. When people combine information gathered at the time of an actual experience with new information acquired later, they form a smooth and seamless memory and thereafter have great difficulty telling which facts came from which time.
More specifically, when people experience some actual event--say, a crime or an accident, or a stock analyst briefing--they often later acquire new information about the event. This new information can contaminate the memory. This can happen when the person talks with other people, is exposed to media coverage about the event, or is asked leading questions.
A simple question such as 'How fast were the cars going when they smashed into each other?' has led experimental witnesses to an auto accident to estimate the speed of the cars as greater than did control witnesses who were asked a question like 'How fast were the cars going when they hit each other?' Moreover, those asked the leading 'smashed' question were more likely to claim to have seen broken glass, even though no glass had broken at all. Hundreds, perhaps thousands of studies have revealed this kind of malleability of memory.
It is not difficult to imagine how experts at leading witnesses, like investment bankers and sell-side stock analysts, can use just the right words to modify what you thought you remembered about the factual information you gathered from your diligent business analysis. Even more frightful, memory researchers have demonstrated that post-event suggestions can do more than alter memory for a detail here and there from an actual experienced event; it can create entirely false memories.
In one illustrative example of false memories, subjects filled out questionnaires and answered questions about a trip to Disneyland. One group read and evaluated a fake Disneyland ad featuring Bugs Bunny and describing how they met and shook hands with the character. About 16% of the people who evaluated the fake Bugs ad later said that they had personally met Bugs Bunny when they visited Disneyland. Later studies showed that with multiple exposures to phony Disney ads involving Bugs, the percentages rose to 30%. The problem is that Bugs is a Warner Brothers character not to be found at Disneyland.
What shall we do with all we have learned about the malleable nature of memory? We might start by recognizing that a reconstructed memory that is partly fact and partly fiction might be good enough for many facets of life but inadequate for legal purposes (eyewitness testimony) and certainly inadequate for making intelligent investment decisions, where very precise memory often matters.
Judges and investors need to appreciate a point that can't be stressed enough: True memories cannot be distinguished from false without corroboration. If a stockbroker analyst or financial journalist or economist tells you the current situation resembles a past situation (and thus assumes predictive value from their memories of the past situation applied to the current situation), seek out as much factual evidence to corroborate such statements as is possible before accepting the memory-based correlation and prediction.
Sage@wallstraits.com
This exerpt is from Chapter 1 of our Professor Sage book The Prehistoric Investor: Exploring the Ancient Minds of Modern Investors. You can get your very own copy free by joining (or renewing) Intelli-Vest, or purchase online.
Copyright @ 1999-2005 WallStraits.com Pte Ltd. All rights reserved
THE PREHISTORIC INVESTOR I
How The Mind Works
After an event occurs just two or three times in a row, regions of the human brain called the anterior cigulated and nucleus accumbens automatically anticipate that it will happen again. If it does repeat, a natural chemical called dopamine is released, flooding your brain with a soft euphoria. Thus, if a stock goes up a few times in a row, you reflexively expect it to keep going--and your brain chemistry changes as the stock rises, giving you a natural high. You effectively become addicted to your own predictions.
-- Jason Zweig
The mind has to be built out of specialized parts because it has to solve specialized problems. Only an angel could be a general problem-solver; we mortals have to make fallible guesses from fragmentary information. Each of our modules solves its unsolvable problem by a leap of faith about how the world works, by making assumptions that are indispensable but indefensible--the only defense being that the assumptions worked well enough in the world of our ancestors.
-- Steven Pinker
Human Instincts
Investors are humans, so investor psychology is all about human psychology, which is directly related to understanding how the human brain/mind works. To understand our instincts and behaviors we need to gain a historical perspective on the evolution of our modern species from more ancestral predecessors. Our human brain, after all, is very close in design to that of our closest relatives, such as the chimpanzee--but, as Steven Pinker notes, the human brain is far more accomplished.
We are naked, lopsided apes that speak, but we also have minds that differ considerably from those of apes. The outsized brain of Homo sapiens sapiens is, by any standard, an extraordinary adaptation. It has allowed us to inhabit every ecosystem on earth, reshaped the planet, walk on the moon, and discover the secrets of the physical universe. Chimpanzees, for all their vaunted intelligence, are a threatened species clinging to a few patches of forest and living as they did millions of years ago.
Yet despite the admirable accomplishments of man, especially in the fields of science and industry, we struggle clumsily when it comes to making intelligent investment decisions. How can that be? It would seem immensely simpler to build a high-return stock portfolio than to build a space shuttle, after all. But struggle we do when it comes to stock market investments, and the major reason is that we have inherited a set of powerful instincts from our ancestors that are maladapted to modern financial markets.
Why are ancient instincts so powerful? You must consider that modern man began to evolve from earlier great apes in Africa about 5-7 million years ago, and only about 13,000 years ago did our Homo sapiens ancestors succeed in populating all major landmasses. So, what we consider modern times, or 'historic' times (as opposed to 'prehistoric times')--man living in large communities with organized oral and written language, specialized careers, commerce and trade and such--is, on an evolutionary time scale, just the blink of an eye. So, after evolving a set of instincts and behaviors that were nurtured by the forces of natural selection over thousands and thousands of generations, we were all of a sudden thrown into a modern environment that in many ways we are not well adapted to. Let's look at some examples of our poorly adapted state as it relates to the field of investment.
Pattern Biases
When our most ancient ancestors first learned that pattern recognition in nature could offer predictive value, they had happened upon a distinct competitive advantage. Day followed night, the moon appeared after sunset, cold seasons were followed by warm seasons; wet seasons were followed by dry seasons, etc. Being able to predict the future based on assuming observed patterns would be repeated perpetually allowed our ancestors to be prepared for expected changes, whether it meant storing some extra food and water or building a shelter.
Unfortunately, not all observed sequences have patterns that repeat. Nonetheless, when there are not patterns, we instinctively invent them, and also instinctively use imaginary patterns to predict the future (see chart readers or technical analysts).
Memory Modifications
We think our memories are much more accurate then they really are. I first learned this surprising fact when reading The Best American Science And Nature Writings 2003, which included a reprint of an article from Issues in Science and Technology called 'Memory Faults and Fixes' by Elizabeth F. Loftus.
Loftus began the article by suggesting courts of law change their swearing in statement to, 'Do you swear to tell the truth, the whole truth, or whatever it is you think you remember?' She noted that year 2003 saw the release of the hundredth person from U.S. prisons that had been convicted on the basis of eyewitness testimony and later (sometimes many years later) freed on the basis of genetic evidence testing.
Loftus documents that a variety of psychological studies have shown that it is vurtually impossible to tell the difference between a real memory and one that is a product of imagination or some other process. It turns out that memories are not fixed but remain modifiable or malleable in our minds. Our memories are vulnerable to 'post-event information': to details, ideas, and suggestions that come along after an event has happened. People integrate new materials into their memory, modifying what they believe they personally experienced. When people combine information gathered at the time of an actual experience with new information acquired later, they form a smooth and seamless memory and thereafter have great difficulty telling which facts came from which time.
More specifically, when people experience some actual event--say, a crime or an accident, or a stock analyst briefing--they often later acquire new information about the event. This new information can contaminate the memory. This can happen when the person talks with other people, is exposed to media coverage about the event, or is asked leading questions.
A simple question such as 'How fast were the cars going when they smashed into each other?' has led experimental witnesses to an auto accident to estimate the speed of the cars as greater than did control witnesses who were asked a question like 'How fast were the cars going when they hit each other?' Moreover, those asked the leading 'smashed' question were more likely to claim to have seen broken glass, even though no glass had broken at all. Hundreds, perhaps thousands of studies have revealed this kind of malleability of memory.
It is not difficult to imagine how experts at leading witnesses, like investment bankers and sell-side stock analysts, can use just the right words to modify what you thought you remembered about the factual information you gathered from your diligent business analysis. Even more frightful, memory researchers have demonstrated that post-event suggestions can do more than alter memory for a detail here and there from an actual experienced event; it can create entirely false memories.
In one illustrative example of false memories, subjects filled out questionnaires and answered questions about a trip to Disneyland. One group read and evaluated a fake Disneyland ad featuring Bugs Bunny and describing how they met and shook hands with the character. About 16% of the people who evaluated the fake Bugs ad later said that they had personally met Bugs Bunny when they visited Disneyland. Later studies showed that with multiple exposures to phony Disney ads involving Bugs, the percentages rose to 30%. The problem is that Bugs is a Warner Brothers character not to be found at Disneyland.
What shall we do with all we have learned about the malleable nature of memory? We might start by recognizing that a reconstructed memory that is partly fact and partly fiction might be good enough for many facets of life but inadequate for legal purposes (eyewitness testimony) and certainly inadequate for making intelligent investment decisions, where very precise memory often matters.
Judges and investors need to appreciate a point that can't be stressed enough: True memories cannot be distinguished from false without corroboration. If a stockbroker analyst or financial journalist or economist tells you the current situation resembles a past situation (and thus assumes predictive value from their memories of the past situation applied to the current situation), seek out as much factual evidence to corroborate such statements as is possible before accepting the memory-based correlation and prediction.
Sage@wallstraits.com
This exerpt is from Chapter 1 of our Professor Sage book The Prehistoric Investor: Exploring the Ancient Minds of Modern Investors. You can get your very own copy free by joining (or renewing) Intelli-Vest, or purchase online.
Copyright @ 1999-2005 WallStraits.com Pte Ltd. All rights reserved
posted by mrmoon at 3:01 AM
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