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Markets: Lizard Brains ?
New York: February 18, 2008
By John R. Stephenson

Why is Warren Buffett the exception rather than the rule when it comes to investing? It all seems so simple. Buy low, sell high. But in study after study, investors rush in to buy when they should be worrying and sell in frustration at exactly the time when they should be buying. Why is it that the price of a single tulip was equal to the price of a nice house in Amsterdam during the Dutch tulipmania of the 1600's? Investing is often a frustrating, complicated and demoralizing experience that leaves many wondering if they are going crazy .

People are crazy, at least some of the time. This irrational behavior appears at the most inopportune times — namely, when we act as stock investors. This is why individual investors systematically underperform the market and why Warren Buffett is an investing anomaly. But isn't this different than what we've been led to believe? Isn't stock analysis a rational, logical exercise? No.

The Efficient Market Hypothesis and earlier academic work on markets and investing have been premised on one key finding — that investors are rational and they make investment decisions solely on the basis of rational weighing of both risk and reward. The theory postulates that "you can't beat the market" because all relevant information is already reflected in the stock price (i.e. the market is efficient). For years, this was the dogma that was peddled as gospel, in the world's leading business schools.

But lately, a growing body of scientific evidence is emerging that has caused researchers to cast doubt on the Efficient Market Hypothesis. There seems to be ample evidence that markets are, in fact, irrational — often pricing securities at ridiculous bargains, or, very dearly. If markets were rational, then the price of a single tulip during the height of the Dutch tulipmania (1635) could never have approached the cost of an Amsterdam home. Similarly, if markets were rational, internet stocks could never have traded at 300x P/E multiples. The likely conclusion is that markets exhibit irrational behaviors because the investors who make up the stock market are, at least at times, irrational. In other words, profitable trends exist in markets.

Recently, Dr. Terry Burnham and other academics have been researching in a new field of behavioral finance which he refers to as the science of irrationality. In his recent book, Mean Markets and Lizard Brains, Dr. Burnham postulates that the human brain is really divided into two parts. The first is the prefrontal cortex that is located above the eyes and is responsible for rational calculations. In comparison with other animals, humans have extremely large prefrontal cortexes which explains why we have superior reasoning ability. While we are certainly capable of making very rational decisions, another ancient part of the brain is often involved in decision-making and its influence is far greater than we suspect.

Figure 1: The Influence of the Lizard Brain Looms Large

 

The other part of the brain he describes as the lizard brain, which is the older, larger portion of the brain and is responsible for many of our subconscious actions. The lizard brain is the ancient, less cognitive, portion of the brain that often exerts a powerful influence on us. This lizard brain has evolved over centuries and has helped us to reproduce, find food and survive in the wild. In particular, the lizard brain is a pattern-seeking, backward-looking system that worked well in the world of our ancestors, but in the modern world of investing, its powerful influence over our actions is potentially disastrous.

The most striking feature of the research of irrationality is that while the prefrontal cortex is essential for conducting the type of analysis required for stock investing, it is often overridden by the larger more dominant lizard brain. Not only that, but the lizard brain often has goals that are different from and possibly in conflict with those of the logical, rational brain. Worse yet, studies have revealed that we often are unable to recognize the influence that the lizard brain is having on our decision-making. By design, human beings are built to cover up our lizard brain influences, meaning that irrational acts often have rational explanations — at least as far as we as individuals are concerned. We really are crazy and markets are really irrational.

This all-pervasive influence of the lizard brain on our behavior goes a long way to explaining why investors have the uncanny ability to be at maximum pessimism just before bull markets and overly optimistic at market tops. It's also the reason why there is only one Warren Buffett who through his investment vehicle, Berkshire Hathaway, has returned a compounded annual return of 22.2% over the past 40 years.

But the lizard brain serves an important purpose. It is what has allowed us to survive, to breed and to hunt for food. The problem is that today we find ourselves in a very different world than our ancestors. Unfortunately, our brains and bodies have not evolved at the same rate as our societies have.

In ancestral times, we hunted animals and foraged for food. Our brains were designed for recognizing patterns in events even if there are none present. This feature of the lizard brain allowed humans to study the grazing patterns of animals, recognize patterns in their behavior and be able to hunt them successfully. Unfortunately, this backward looking nature of the lizard brains puts us on a collision course with the world of today — particularly the world of investments. If we are "by design" destined to find patterns in past data, then we are going to do more of what has been working rather than looking out for what will work. Our lizard brain has predisposed us to investment failure rather than success.

Humans are social animals. We love the company of others and seek companionship and inclusion in social affairs. When we act in a way that has led to happiness or successful outcomes, we have a strong biological response — our brains are literally bathed in dopamine, a powerful natural barbituate. Investments that feel good are precisely the ones that are most likely to cost us money and the ones that feel bad are the ones that will allow investors to prosper. No wonder people often feel that investing is driving them crazy — it may in fact be doing that.

But if irrationality rules the day and stocks aren't efficient what can savvy investors do about it? For starters, we should start by recognizing the irrationality in our own behavior and accepting that it exists. Next, we need to understand that in order to survive and prosper in the world of investments, we need to predict what everyone else is doing and move to profit from their behavior. In short, we need to find a way to circumvent the influence of our lizard brain and rely more heavily on the rational prefrontal cortex part of our brains.

So what's a savvy investor to do? We need to avoid circumstances where we allow our emotions (the influence of our lizard brain) to have control over our investments. In other words, don't trade when you are feeling emotional. Better yet, trade less frequently since many of the trading urges that we experience are really the influence of our lizard brain over our more rational prefrontal cortex.

Avoid temptation. Watching too much financial television, spending hours in front of a trading screen or buried in financial press, will likely activate your lizard brain and cause you to trade unnecessarily and often at the worst possible moment.

Don't average down or dollar cost average. Most of us hate losses and will do anything to avoid taking a loss or recognizing a loss including buying more (averaging down) of what is not working under the fallacy of "it couldn't get much worse." It can. In the famous investment classic of 1923, Reminiscences of a Stock Operator , the book counsels: "Of all the speculative blunders there are few greater than trying to average a losing game. Always sell what shows you a loss and keep what shows you a profit."

Don't dollar cost average. Dollar cost averaging is a bull market strategy and will be disastrous if the markets are in bear market territory. In other words, dollar-cost averaging in flat or declining markets is just another form of averaging losers.

Employ a quantitative screen. In order to succeed as an investor, you need to find a way to avoid the influence of your lizard brain. By screening for cheap stocks quantitatively you engage your prefrontal cortex and at least have a reasonable hope of overriding the irrational lizard brain and its undo influence.

Dare to be different. Warren Buffett endured years of ridicule during the dot com mania as others questioned how he could be so hopelessly out of step with the mainstream investing public. Few would have had the internal strength to stay the course. Naturally, he persevered and has emerged on top, while many of the flash in the pan investors of the 1990s are now bankrupt.

Financial markets are fraught with risk. Investing is complicated by the unseen but ever present influence of our ancestral lizard brain that is ill equipped to deal in the modern world of investing. Only by first being aware of its influence and then by harnessing its influence can we come out on top in this bizarre, frustrating and occasionally rewarding game of high stakes poker.

StephensonFiles is a division of Stephenson & Company Inc. an investment research and asset management firm which publishes research reports and commentary from time to time on securities and trends in the marketplace. The opinions and information contained herein are based upon sources which we believe to be reliable, but Stephenson & Company makes no representation as to their timeliness, accuracy or completeness. Mr. Stephenson writes a regular commentary on the markets and individual securities and the opinions expressed in this commentary are his own. This report is not an offer to sell or a solicitation of an offer to buy any security. Nothing in this article constitutes individual investment, legal or tax advice. Investments involve risk and an investor may incur profits and losses. We, our affiliates, and any officer, director or stockholder or any member of their families may have a position in and may from time to time purchase or sell any securities discussed in our articles. At the time of writing this article, Mr. Stephenson may or may not have had an investment position in the securities mentioned in this article
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