Humans have a remarkable ability to detect patterns. That's helped
our species survive, enabling us to plant crops at the right time
of year and evade wild animals. But when it comes to investing,
this incessant search for patterns causes more heartache than
anything else.
We see that value funds have stunk for years, so we dump them
and pile into fashionable growth stocks like Intel and
Cisco--right before they hit the skids.We buy a stock because
some guy at a barbecue recommended it, and everything he talks
about seems to go up--but this one plunges. We put every dime in
stocks after hearing that they've trounced bonds forever--only
to see bonds zoom past stocks this year.
Our incorrigible search for patterns leads us to assume that
order exists where it often doesn't. Many of us believe, for
example, that it's possible to foresee where the market is
heading or whether a particular stock will continue to rise. In
reality, these things are far more random and unpredictable than
we like to admit.
Remarkably, scientists are now finding that this tendency to look
for patterns is hardwired into the human brain. Psychologists
have long known that if rats or pigeons knew what the Nasdaq is,
they might be better investors than most humans are. That's
because, in some ways, animals are better than people at
predicting random events. If, for instance, you set up two lights
in a laboratory and flash them in a random sequence, humans will
persistently try to predict which of the two lights will flash
next. Stranger still, they'll keep trying even when you tell them
that the flashing of the lights is purely random. Let's say you
flash a green light 80% of the time and a red one 20% of the time
but keep the exact sequences random. (A run of 20 flashes could
look something like this: GGGGRGGGGGGGRRGGGGGR.) In guessing
which light will flash next, the best strategy is simply to
predict green every time, since you stand an 80% chance of being
right. That's what rats or pigeons generally do in a similar
experiment that rewards them with a crumb of food whenever they
correctly guess the next outcome.
But humans are apparently convinced that they're smart enough to
predict each upcoming result even in a process they've been told
is random. On average, this misguided confidence leads people to
get the right answer in this experiment on only 68% of their
tries. In other words, it's precisely our higher intelligence
that leads us to score lower on this kind of task than rats and
pigeons do.
The man with two brains
A team of researchers at Dartmouth College, led by psychology
professor George Wolford, has been studying why it is that we
think we can predict the unpredictable. Wolford's team ran
light-flashing experiments on "split-brain patients"--people in
whom the nerve connections between the hemispheres of the brain
have been surgically severed as a treatment for epilepsy. Here's
the group's key discovery, which was recently published in the
Journal of Neuroscience: When the epileptics viewed a series of
flashes that they could process only with the right side of their
brains, they gradually learned to guess the most frequent option
all the time, just as rats and pigeons do. But when the signals
were flashed to the left side of their brains, the epileptics
kept trying to forecast the exact sequence of flashes--sharply
lowering the overall accuracy of their predictions.
Wolford's conclusion: "There appears to be a module in the left
hemisphere of the brain that drives humans to search for patterns
and to see causal relationships, even when none exist." His
research partner, Michael Gazzaniga, has christened this part of
the brain "the interpreter." Wolford explains: "The interpreter
drives us to believe that 'I can figure this out.' That may well
be a good thing when there is a pattern to the data and the
pattern isn't overly complicated." However, he adds, "a constant
search for explanations and patterns in random or complex data is
not a good thing."
The dance of happenstance
Trouble is, the financial markets are almost--though not quite--as
random as those flashing lights. On CNBC and countless websites,
investment strategists and other so-called experts scan the
momentary twitches of the market and predict what will happen
next. Far more often than they're right, they're wrong--and the
Dartmouth discovery about the interpreter in our brains helps
explain why. These pundits are examining a chaotic storm of data
and refusing to concede that they can't understand it. Instead,
their interpreters drive them to believe they've identified
patterns upon which they can base predictions about the future.
Meanwhile, the interpreters in our own brains impel us to take
these seers more seriously than their track records deserve. As
Berkeley economist Matthew Rabin has pointed out, just a couple
of accurate predictions on CNBC can make an analyst seem like an
ace, because viewers have no way to sample the analyst's entire
(and probably mediocre) forecasting record. In the absence of a
full sample, our interpreters take over and lead us to see the
analyst's latest calls as part of a pattern of success.
The interpreter also helps explain what's called the gambler's
fallacy--the belief that if, say, a coin has come up heads several
times, then it's "due" to come up tails. (In fact, the odds that
a coin will turn up tails are always 50%, no matter how many
times in a row it's come up heads.) The gambler's fallacy is as
common on Wall Street as hairballs under a couch: Some pundits
will say emerging markets are sure to rebound because they've
been doing badly for years, while others say tech stocks will
crash because they've risen so much. In reality, the market makes
mincemeat out of most of our predictions; apparent trends often
foretell little about the future.
In its constant search for patterns, the interpreter also tricks
investors into believing that hot performance streaks are sure to
persist. Based on a few months of scorching returns, investors
piled into Internet stocks late last year--and are now sitting on
returns as cold as liquid nitrogen. What's happening here is
simple: As soon as a pattern seems to emerge in the market, the
interpreter in our brains sees it as part of a predictable
trend--rather than a random happenstance that may never be
repeated.
Finally, I think the Dartmouth research helps solve another
puzzle. Even when we have only a small sample of our own
performance at risky tasks--a few yanks on a one-armed bandit or a
handful of big scores on tech stocks--we tend to decide either
that we know what we're doing or that we're on a lucky streak. We
almost never conclude that our success is the result of chance
alone. Dutch psychologists Willem Wagenaar and Gideon Keren have
found that professional gamblers, when accounting for their wins
and losses, greatly overestimate the role of skill, attributing
just 18% of the outcome of each bet to random chance.
Similarly, when a day-trader makes a fat profit off a stock after
doing no research and owning it for only seconds, he's likely to
conclude that he's an analytical genius or has an uncanny feel
for the market. In truth, that profit is probably an accident--but
his mind won't allow him to see things that way.
Mind over matter
So how can you keep your brain from giving you a garbled view of
the investment world? You could disable your interpreter once and
for all by having a neurosurgeon separate your brain's two
hemispheres, and then by scrutinizing investment information in
the leftmost part of your field of vision. That way, only the
right half of your brain would be able to process investment
data, and the interpreter would be shut down. However, it won't
be easy talking a surgeon into carving your cranium open for
this, and watching CNBC out of the far corner of your eye might
be a pain. So here are some less drastic options.
Don't obsess. In one of his most startling findings, George
Wolford of Dartmouth says people in his experiments earned higher
scores when they were distracted with a "secondary task" like
trying to recall a series of numbers they'd recently seen. In
other words, interruptions improved their performance by
preventing the interpreter in their brains from seeking spurious
patterns in the data. Likewise, continually monitoring your
results will probably make them worse--as you fool yourself into
seeing trends that aren't there and trade too much as a result.
If you're spending more than a few hours a month on investing,
you're not only taking valuable time away from the rest of your
life, but you're almost certainly hurting your returns.
Remember what's at stake. John Staddon, a professor of psychology
at Duke, says rats or pigeons will generally bet on the option
that has had the highest probability of success over time. But,
notes Staddon, "humans will consistently do that only when the
stakes are large and the consequences really matter." So you'll
make better financial decisions if you convince yourself that
there's no such thing as a small or casual investment. Just think
of the thousands of dollars you could squander--and the blissful
retirement you could jeopardize--with a few careless stock picks.
Track your forecasts. Whenever you've got a strong opinion about
where a stock, or the market, is headed, jot it down and note the
date. This will keep you from conveniently forgetting your failed
forecasts and may provide you with a humbling reminder of your
limitations as a soothsayer. And whenever some analyst seems to
know what he's talking about, remember that pigs will fly before
he'll ever release a full list of his past forecasts, including
the bloopers.
Defy the chaos. Not everything about investing is chaotic,
however; a few things really are predictable. On average, over
time, investors who keep costs low (either through index funds or
buy-and-hold stock portfolios) are mathematically certain to
outperform in- vestors who trade too frequently or buy funds with
high expenses. So before you focus on your returns--which are
entirely unpredictable--make sure that your investments are not
overpriced.
Diversification is another principle that defies chaos. Consider
the danger of investing almost exclusively in tech stocks. Many
investors who bet heavily on the sector in 1982--the last time it
was this hot--loaded up on market darlings such as Alpha
Microsystems, Commodore, Tandy, Vector Graphic and Wang
Laboratories, which later tanked. If you diversify--by owning a
wide range of U.S. and foreign stocks and bonds--you virtually
eliminate the chance that a few duds like these will ruin your
financial future. Broad diversification is still the best
insurance against the risk of making an investment mistake. And
there's nothing random about that.
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