Investing = f(dopamine flow); money=> peace of mind

Neuroeconomics is a new science that is taking the investing world by storm, though, until recently, it was confined to the academic circles. Now, through his book, ‘Your Money and Your Brain - How the New Science of Neuroeconomics’ Can Make you Rich, Jason Zweig has tried to take neuroeconomics to the layman. The subject, as Zweig defines it, is “a hybrid of neuroscience, economics and psychology,” which helps us understand “what drives investing behaviour not only on the theoretical or practical level, but as a basic biological function.”

Zweig is a senior writer for the Money magazine and has been a guest columnist for Time and cnn.com. He is also the editor of the revised edition of Benjamin Graham’s ‘The Intelligent Investor’. In an interview to Vivek Kaul, Zweig speaks on Neuroeconomics and his philosophy of investing.

You seem to suggest in your book that investors should not fall for the story behind the stock. What else does one look at, then?

The key is to understand a crucial distinction, first drawn by the great investor Benjamin Graham, who was Warren Buffett’s teacher.

Stocks and businesses are not the same thing. Stocks flit around all the time; you can watch them moving up and down on your computer screen all day long.

In New York, it’s not unusual for the price of a stock to change at least 10,000 times in a single day of dealing, and I imagine it’s not very different in Mumbai.

Stock prices are in constant flux, but business values are not. The underlying value of an ongoing enterprise does not change every day. Something like 99% of all the trading activity in the typical stock is meaningless.

The future value of a business has nothing to do with the current price of its stock. What you should do is learn to look past the noisy twitching of stock prices to the enduring value of businesses as living organisms.

Is the business run by honest people who treat outside investors fairly? Does it make products or provide services for which customers are willing to pay higher prices if necessary? Can you understand its financial statements?

These constitute the reality of the business and determine its future value. The “story” behind the stock is almost certainly nothing more than the stampede of thousands of speculators in and out of the shares.

Train yourself to ignore them.

“The best financial decisions draw on the dual strengths of your investing brain: intuition and analysis, feeling and thinking,” you write. Isn’t there a dichotomy there?

Yes, there is. But let’s get our terminology straight, and again we can do so by going back to Benjamin Graham.

Graham’s formal definition has never been improved upon: “An investment operation is one which, upon thorough analysis, promises safety of principal and an adequate return.”

Notice carefully that this is neither an “or” nor an “and/ or” definition; all three components - analysis, safety, and an adequate result - must be present. If any of them is missing, you are not investing.

You are speculating.  In India, as in the United States, most people who call themselves “investors” are not investors at all. They are speculators.

In the short run, particularly while the Indian capital markets are rapidly developing, speculators may be able to earn high returns by rapidly trading stocks without doing thorough analysis.

But in the long run, you cannot earn sustainably high returns from mere “gut feelings.”

I find it striking that in a society with cultural traditions of great patience and acute analytical ability, so many people trade as if their knickers were afire, scoffing at the long term and analysing nothing but the craziness of the crowd.

There is no doubt in my mind that Indians have the potential to lead the world in investment skill. But, so far as I can tell from my faraway vantage point, what most Indians do is not investing.

In my own portfolio, I do not invest with the next year in mind, nor even with the next decade in mind. I invest with the next century in mind; that is when my heirs will benefit from my decisions.

I do not care what stock prices do this afternoon, or this week, or this month, or this year. I care whether business values are rising.

That is what it means to be an  investor.

You have written about the link between dopamine and the way investors invest.

What’s the link?

Dopamine makes us pursue whatever we think will be rewarding. When we earn more than we expected, that generates a “positive prediction error” - a flood of dopamine that signals to our bodies that something good has happened.

After only a few repetitions, the dopamine is released in our brains, not when we earn the actual gain, but when we believe we know that the gain is coming.

It is not the reward but the prediction of it that generates pleasure in the brain. I call this the “prediction addiction.”

You become addicted to your own belief that you are about to make money. Like any addict, when the reward does not come, you will go into a painful withdrawal.

Why do investors get greedy? Even Isaac Newton lost most of his money in the South Sea Bubble. What does Neuroeconomics have to say on that?

Greed is generated in the same regions of the brain that produce pleasure when we find food or shelter or love. These basic reward circuits are among the oldest systems in the human brain.

Geniuses have them, too. Brilliant people are better at generating great ideas than the rest of us, but they are no better at controlling their own emotions than you or I.

We get greedy because the anticipation of profits activates the dopamine system in the brain, flooding our neurons with a signal of excitement.

Newton was not just one of the smartest men of all time, but was also very well-informed financially; he was the master of the Royal Mint.

So he certainly knew better in the “thinking” part of his brain. But his “feeling” brain was swept away with greed.

If you do not put policies and procedures in place, in advance, to control your emotions, you will never be able to resist the siren song of the markets when the markets go mad.

Common sense and good judgment are vastly more valuable than intelligence.

What makes investors book profits fast, but hold on to their losses?

We do not merely buy stocks and sell them. What we really are buying is pride and prowess, and what we really are selling is pain and shame.

Once a stock earns a large gain, you want to lock in the reason for your pride and the proof of your prowess; if you hang on too long, the profit may disappear.

But, once a stock produces a big loss, you want to hide the source of your pain and shame.

If you sell at the bottom, you will have to admit your error, and that admission will only compound your shame. Whenever humans are ashamed of anything, we cover it up. So we cover our financial losses by pretending they are not there.

So, what is the best way to invest?

My fondest wish for Indian investors is that index-tracking funds will become widely available at very low management fees and dealing costs.

If I were an Indian financial entrepreneur, I would study US firms like Vanguard, Barclays Global Investors and Dimensional Fund Advisors to learn how they run their tracking funds so efficiently and fairly.

And if I were a young Indian investor, I would embrace low-cost tracking funds and put most of my money there for the very long run.

The combination of diversification, simplicity, convenience, and low cost provides an insuperable advantage to the tracking investor.

The life of a rising professional is busy enough without having to spend precious time and emotion following every momentary rise and fall of every stock you own. If your money cannot buy you peace of mind, why invest at all?  

 

 

 

 

 

 

 

Does luck have a role in investing?
Luck has a great deal to do with it. Whenever a stock trades, the buyer thinks the seller is making a mistake. The seller thinks the buyer is mistaken. Only one of them can be right. After they both pay their dealing costs and any taxes on the transaction, neither may show any net profit for his pains. In the short run, almost anyone can be right a few times in a row, by luck alone - just as anyone can flip a coin right-side up several times in a row without any coin-flipping skill, whatsoever. Even in the long run, luck can rule the day. It can take years, even decades, to determine whether an investor has genuine and repeatable skill or is just lucky. The danger comes when you believe you are skillful and, in fact, you turn out to be merely lucky. Then you do things out of a belief that every step you take is the right one, and you end up slipping on a banana peel and falling down the stairs.
You talk about the “illusion of control.” Investors tend to be over-optimistic when they are directly involved and have had no negative experience from the over-optimism. How does this affect investing decisions?
It is easy to believe “I did it” when a stock you buy goes up. However, your actions did not cause the price to rise. Ask yourself this: If I had not bought the stock at all, would it not have risen without me?
The way to escape the illusion of control is to invest with the aid of a checklist, a series of rules you must always follow before buying or selling any investment. This way, the rules make the decisions for you, and you take your pride out of the picture, enabling you to be more objective. In my book, I outline some rules that may be useful for many people.
Can financial future be foretold?
Some things can be. I am very confident predicting that the Indian stock market will lose a third of its value over the course of a few months. However, I have no idea, whatsoever, when this will happen. I am equally confident predicting that the Indian stock market will rise ten-fold and more over the long term. And I am more confident still in predicting that the true investors who have the courage to buy when the market crashes will make much more money in the long run than the fools who buy only when stocks go up.
Why are investors so addicted to CNBC? Their broadcast gives a feeling the “stock markets are in a crisis all the time.” Does that have an impact on the way investors invest?
Years ago, you could only find out a stock price in tomorrow’s (or sometimes, the next week’s) newspaper. Now you can find out the latest price every few minutes on CNBC or every few seconds online. This is the tragedy of technology - that the tool that should make us wiser, instead makes us act more foolishly than ever before. The human brain is a pattern-recognition machine. The more frequently you look at a series of data, the more often you will see “trends” and patterns that are not really there; they are nothing more than chaos clothed in a costume of regularity, illusions of order in streams of data that are utterly random. After two consecutive stimuli in the same direction, the human brain automatically, involuntarily, and uncontrollably expects a third. We extrapolate repetition out of what actually is randomness. CNBC is addictive because it continuously presents you with the opportunity to perceive what is not actually there: order, predictability, reliable patterns. It grips us the way all great fiction is gripping, with the added irony that very few of us realise that what we are watching is actually fiction.
Most of the investment experts do not really give any usable information. Is not listening to such experts better than taking them seriously?
I would listen very seriously to any financial expert who would provide a comprehensive record of every forecast he has ever made, both good and bad. Many forecasters will tell us about every single one of their successes. However, to the best of my knowledge, there is no financial forecaster alive who has ever provided a complete list of all his predictions, including the failures. There’s a reason for that: Anyone who really knew how to forecast the financial future would be most unlikely to let others in upon his secrets.