HOW emotions AFFECT YOUR INVESTING
In the last decade, however, a field called "Behavioral Finance" has become more and more popular to explain investor behavior and the price action of stocks that cannot be explained by an efficient market. In fact, IntelligentValue.com newsletter seeks to take advantage of the irrational decisions that the majority of people make by using a contrarian approach to investing.
By Christopher Michaels
IntelligentValue.com
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As Warren Buffett says (and I paraphrase), in the short term, "Mr. Market" is an emotional partner that on any given day will sell any stock at any price, which gives us excellent opportunities to buy good stocks an incredibly low prices. In the long-term, "Mr. Market" is rational and will provide a long-term price that truly reflects a business's prospects.
Why is 'Mr. Market' such an emotional fellow? He seems to be whipsawed constantly by the emotions of fear and greed. Most of us consider ourselves to be different; we're rational and not like all the investors out there that have out-of-control emotions. But self-analysis can be a sticky wicket. Are we really as rational as we think we are?
Our brains have evolved over hundreds of millions of years with layer upon layer of sophistication. With modern parts atop old ones, the brain is like an iPod built around and 8-track cassette player. At the very core of our brain is the same one that existed in the lizards we evolved from.
Most of the time, we use our more highly developed brain material when making decisions, but money is a different matter. It becomes lumped in with the other core emotional decisions, such as fight or flight, risk avoidance, sex, and survival. These basic, simple brain functions usually serve us well when we are faced with basic challenges. But our brain puts financial issues in the "emotional" category along with risk avoidance and survival and we make low-level decisions that have the opposite effect we are seeking.
In fact, when we are seeking to avoid risk regarding money matters, studies have shown that humans instead choose "increased risk" solutions to various financial decisions.
In 2002, Professor Daniel Kahneman of Princeton University developed what he called "Prospect Theory." His work won him and his partner, Amos Tversky, the Nobel Prize in Economics and is the basis of what is now called Behavioral Finance. In the last five years, Behavioral Finance has become the dominant psychological theory behind investing. Most individuals never consider how psychology may be affecting their decisions, but they should. It is the #1 reason that 99% of investors lose money in the stock market.
The more we understand about Behavioral Finance, the more we can take advantage of others', seemingly unexplainable, actions. To help us exploit the mistakes of other individuals, we must study their innate human tendencies - and make sure we are not making these same mistakes ourselves.
One very important result of Kahneman's and Tversky's work is demonstrating that people's attitudes toward risks concerning gains may be quite different from their attitudes toward risks concerning losses. For example, when given a choice between getting $1000 with certainty or having a 50% chance of getting $2500 they may well choose the certain $1000 in preference to the uncertain chance of getting $2500 even though the mathematical expectation of the uncertain option is $1250. This is a perfectly reasonable attitude that is described as risk-aversion. But Kahneman and Tversky found that the same people when confronted with a certain loss of $1000 versus a 50% chance of no loss or a $2500 loss often choose the latter risky alternative. This is called risk-seeking behavior. This is not necessarily irrational but it is important for analysts to recognize the asymmetry of human decision making.
In contrast to old-school assumptions of cool-headed rationality, the new behavioral school embraces hot-blooded human irrationality as a core feature of both individuals and financial markets. The 2002 Nobel Prize in Economics was awarded to scholars of this new scientific study of human irrationality.
Terry Burnham's Studies on the "Lizard Brain"
TERRY BURNHAM is a leader in the application of biology to economics and finance. He was an economics professor at Harvard for many years, beginning at the Kennedy School and, most recently, at the Harvard Business School. Before joining the Harvard faculty, he worked at Goldman Sachs & Co. Dr. Burnham has a PhD in business economics from Harvard University, a master's in finance from MIT, an MS in computer science from San Diego State University, and a BS in biophysics from the University of Michigan. Dr. Burnham has recently written a book titled, "Mean Markets and Lizard Brains ; How to Profit from the New Science of Irrationality." ($21.05, BestPrices.com)
In an Investor's Business Daily interview, Dr. Burnham says there are biological causes for irrational financial behavior, and it's why panics and crashes happen. He says those who are the most successful at amassing capital, making money, are people who have systems in place to guard against "emotional decisions," use quantitative analysis and are extremely disciplined. Many times, these people use a team approach to managing finances.
A recent MIT study of professional traders confirms this theory: The least emotional were the most successful.
According to Dr. Burnham's book and other's work on Behavioral Finance, there are clear behavioral causes to investor irrationality. The human brain contains ancient structures that exert powerful and often unconscious influences on behavior. This "lizard brain" may have helped our ancestors eat and reproduce, but it wreaks havoc with our finances.
Our lizard brain exerts very powerful and unconscious influences on our financial decisions, causing panics, manias and collective rather than individual decision making. Behavioral Finance helps to explain why individuals are "programmed" to buy stocks at irrationally high prices and sell at irrationally low prices. It is the most clear, profound and logical explanation to why stock market investors become what I call "lizard losers," buying high and selling low.
We need to precisely restrain our instincts in order to make money. Unlike neutral games of chance, or ancestral problems like gathering and hunting, financial success means suppressing our 'gut' instincts.
Burnham declares, "By understanding and taming the lizard brain, you can position yourself to prosper in financial markets that often seem downright mean. If you go through and you study the Warren Buffetts of the world and the people who are amassing capital in the world, who are making money in markets, those people have systems in place to not allow their lizard brain to bankrupt them. They don't use impulse, they use quantitative analysis, they use discipline, they use team approaches, a whole range of tactics to constrain their instincts and their emotions."
A SIMPLE Behavioral Finance EXPERIMENT
It's hard not to think of the market as a person with emotions, and, as we observe from afar, irrational actions. Some days it is overwhelmingly enthusiastic, while other days, it is down in the dumps and nothing will bring it back. As individuals, we wish we could sit the market down and have a talk with it. But the best thing we can do is observe its behavior and make money from its irrational behavior - NOT BE A PART OF IT.
Researchers have easily duplicated daily market behavior that deals with hundreds of billions of dollars in a simple experiment you can do with your family. For example, take the experiment that deals with the Importance of Losses vs. the Significance of Gains :
 Offer someone the choice of a sure $50 - or with the flip of a coin, winning $100 or getting nothing. Chances are, the person will pocket the sure $50.
Offer the choice of a sure LOSS of $50 - or with the flip of a coin, losing $100 or losing nothing. Chances are, the subject will choose the coin toss.
Even though the chances of the coin toss are always going to be 50/50, people will take a chance at the possibility of not losing money, instead of the possibility of gaining money, although the chance of losing money is greater in the second scenario coin toss.
Mean Markets and Lizard Brains
In his book "Mean Markets and Lizard Brains," economist Terry Burnham states: “There are biological causes for irrational financial behavior, and it's why panics and crashes happen.” “Compared to other animals, humans have extremely large prefrontal cortexes, which explains our superior reasoning ability," says Burnham. “Yet, since the lizard part is 'more involved than we suspect'; we not only make errors and fall into traps, but also create a cohesive story about our own behavior, which makes it harder to understand the sources of our own actions."
We possess this configuration because the human brain was shaped in the Pleistocene era, when humans had to forage for food. Besides sabotaging our investing instincts, it can contribute to obesity, drug addiction and poverty.
"Our brains, like our bodies, reflect the world of our ancestors. In particular, our lizard brains are pattern seeking, backward-looking systems that used to allow us to forage successfully for food, and repeat successful behaviors. This system helped our ancestors survive and reproduce, but financial markets punish such backward-looking decisions. Consequently, our lizard brains tend to make us buy at market tops and sell at market bottoms," writes Burnham. "The lizard brain is not stupid, but when confronted with problems never experienced by our ancestors it can make us look crazy and cost us money."
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