Talking Neuroeconomics with Jason Zweig

Jason Zweig, a senior writer for Money magazine, is the author of Your Money & Your Brain: How the New Science of Neuroeconomics Can Help Make You Rich, published by Simon & Schuster. He recently spoke with IndexUniverse.com assistant editor Heather Bell about his new book.

Index Universe: How did you get the idea for the book? What got you thinking along the lines of neuroscience?

Jason Zweig: About 10 years ago I started to feel—not that I knew all the answers in conventional finance—but that at least I knew all the questions. I was feeling a little bored and a little restless. So I was on a business trip to somewhere and I was in the airport bookstore and, on a whim, I bought a copy of Scientific American just because it was different. I opened it up and there was this beautiful full-color illustration of a human brain.

I read the article, which was fascinating, and then most of the way through the article was this statement that people who have had their brains surgically snipped in half as a drastic treatment for epilepsy, calculate probability completely differently. I just stopped in the middle of a walkway of the airport and circled it with a red pen, and said, "I've got to find more out about this."

From that point on I was just hooked. It was a long process because neuroscience, in general, and neuroeconomics in particular, are not very acceptable fields for the layman. And I certainly was a layman when I started—and in many ways still am.

Index Universe: For this book, who do you see as your target audience? It seems like it has a lot for the retail investor and for the professional investor.

Zweig: I would hope so. I guess I would say it's really from the viewpoint of an individual investor, but already many professional investors have told me that they've gotten a lot out of it, both in terms of understanding general principles and also some ideas for organizational or procedural improvement in their analytical process or portfolio construction. The book is really about emotion, and even though every investor likes to think of himself as "rational," I never yet have met a human being who was not at least partly emotional. For anyone who does experience emotion when you invest, it's important to understand how emotions are generated in the brain. That's really what the book is about, and how that interacts with your investing choices.

Index Universe: I saw the book as a very strong argument for index funds simply because that human element is largely removed from an index fund. Is this a valid conclusion to draw?

Zweig: Well, sure it is. You know, I'm a huge believer in indexing and I have been for longer than I can remember. Virtually 100% of my own portfolio is in index funds and I actually do not own a single individual stock and haven't for quite some time. My ultimate conclusion is that there's an important distinction that needs to be drawn between what people should do and what they can do. What people should do is they should index their entire portfolio and then go on a 30-year hiatus, and at the end of the 30 years they would have a substantial amount of wealth built up. In the interim they would've been able to live their lives without all the upset of paying attention to the daily fluctuations of the market. That's what people should do, but it's not what they can do.

Very few people have the ability to buy a stock, vault it away in their portfolio and leave it until it makes them wealthy. I think there's a reason for that: The brain is not really very well-suited for that kind of behavior. Most people will buy more when something goes up and either sell it or freeze when it goes down. The brain is really built as a pattern recognition machine and a performance-chasing mechanism, and when you combine automatically perceiving patterns where they don't actually exist with pursuing performance right before it disappears, you have a recipe for disaster, and that's what most people's brains are very good at.

Where I come out from all of that is that most people can't do what they should, so we need to advise them to do what they can, and increasingly my advice for individuals and for financial advisors who serve them is that everybody should have two things: a lockbox and a sandbox. The lockbox has something like 90% of your money in index funds and nothing else. The sandbox, where you have maybe 5% or 10% of your money, is where, if you really want to, you can play a little. There's nothing terribly wrong with getting entertainment out of investing, as long as you understand that that's what you're doing, and as long as you don't do it with all of your money.

Index Universe: Part of the reason the book seemed like an indirect argument for index funds was that you give a lot of advice about the right way to pick stocks in a way that is as free of personal biases as possible, and it's really a very labor-intensive process.

Zweig: Absolutely, it is a lot of work, and I happen to believe that there are great investors. I'm not positive we could identify them in advance, nor do any of them have any of my portfolios, but there are any number of active managers running mutual funds whom I have a lot of respect for and who I believe are very, very good at what they do and may well continue to beat the market in the future. I'm just sure enough about it to give them my money, and in many cases, I'm not sure it's worth paying the premium management fee in the first place. But the one thing all have in common is they really work hard and they think very hard about what they're doing. They have a lot of second-guessing and a lot of checks and balances built into their policies and procedures, and that's what most individual and professional investors lack, and it's why most of them don't do very well—other than the fact that they trade too much.

Index Universe: Is part of the problem that human beings are simply not evolved to operate in the stock market?

Zweig: Why would we be? Evolution has worked to address a very specific problem, which is the survival of the species. Evolution really has only one objective for a species, which is to maximize its reproductive fitness. Evolution customizes us to survive long enough to have offspring. That's what evolution cares about. It doesn't care about option-adjusted spreads or exchange-traded funds or long-term capital management.

The brain has been built to make basic decisions about risk and reward. We don't have financial circuitry in the brain. We haven't evolved to make decisions specifically about money. That's one of the really interesting things about neuroeconomics: It shows very clearly that when you make a decision about a profit, it's processed in the same part of your brain that processes everything else that feels rewarding, like chocolate cake, Cheetos and drugs, sex and rock ‘n roll. When you make a decision about risk and losing money, that's handled by the same kind of circuitry that responds when you face physical risk and mortal danger. There's not much difference in the brain between having a rattlesnake slither across your living room carpet and having some stock you own go down 40 or 50 percent. Basically it's the same response, which is, "I'm in trouble; how do I get out of here alive?" It's very fast. It's incredibly rapid.

Index Universe: Malcolm Gladwell wrote a best-selling book not too long ago called Blink that was about the importance of our immediate and instinctive reactions. A lot of your book was about how our immediate and instinctive reactions can get us in trouble when we're investing. Is your book a kind of anti-Blink?

Zweig: The beef I would have with that sort of argument is that there are circumstances under which intuition or gut feelings are a very good guide. For example, if you and I meet in a coffee shop and we're deciding whether to go into business together, let's say I'm a Web designer and you want to build a website for yourself and you don't want to get into business with somebody who's fishy. Your gut feelings about me would be quite reliable, because if I don't seem trustworthy to you, I'm probably not. That's an example of an intuition or a gut feeling that's very useful.

But if you have a gut feeling about whether you should buy Google stock, that's not useful at all, because intuitions are only reliable in the areas of life where you get good feedback. And you know just from being a human being and from interacting with people your whole life what the cues are for trustworthiness. Am I sitting there with my eyes shifting all over the place? Am I drumming my foot on the floor? Do I not look at you when I talk to you? Do I immediately ask you for your credit card number? Those kinds of things just set off fire alarms in your head, as they should, but there's no way to do that in the stock market—it's just much too complicated an organism. And every time you think you've got some cue that predicts something, the problem is there are a hundred million other people combing through the same data looking for it, and they've already been there. So by the time you notice it, it either isn't really there or other people have already used it. In either case it's not useful to you, but you'll think it will be.

Index Universe: You make the point in the book about how making money produces a similar reaction in the brain to when an addict takes drugs or gambler wins. Did you see any studies or experiments along these lines with fund managers or other financial professionals who are dealing with other people's money?

Zweig: Well, there's very little reason to believe that professionals and individual investors' brains are much different. There's been a lot of psychological research done on this. There isn't much in neuroeconomics yet, but based on 20 years of observing the financial markets I certainly don't see any evidence that professionals are more rational investors than individuals. There's certainly a fair amount of anecdotal evidence that they're less rational, but they're certainly not more. And there's no real reason why you would expect them to be.

Index Universe: When you were doing your research, was there anything in particular that really shocked or surprised you when you were talking to these different scientists?

Zweig: The really surprising thing is how little we know about how we think. J.P. Morgan once said that every man has two reasons for everything he does: the reason he states and the real reason. I think he meant something a little different by it, but what a neuropsychologist or a neuroeconomist would say is that most of us don't even know why we do things ourselves, and we can often be in the grip of unconscious emotion or unconscious biases, feelings and inclinations that are in our mind but we have no awareness of. By definition, this is one of the hardest ideas you can ever get someone to admit.

I know this is true because of all the speeches I do. When you say to people you may be feeling an emotion you're not aware of, people find that impossible, because they say, "Well, how could it be a feeling if I can't feel it?" The answer is you do feel it; you just can't articulate it and you may not be aware that it's there until after it passes.

For example, if you're watching CNBC and the market is plunging and Jim Cramer is throwing furniture and biting the heads off live chickens, you may be sort of watching it saying, "Oh wow, something really bad is happening; the market is crashing." But while you're watching it your palms are sweating, your breath is coming fast, your pulse is racing, your muscles are tensing, your entire body is on red alert. You're intensely upset by what's happening in front of you, but the thinking part of your brain is so busy trying to make sense of it that it's not aware of what the emotional part of your brain is experiencing. And if in that moment you are suddenly called on to make a choice, "Should I sell this stock or should I hold it?" ... If you're making that choice at that moment while Jim Cramer is screaming in your face, you will not buy and it's highly unlikely that you'll hold ... because all of that screaming, all the red, all the downward pointing lines are so upsetting that you will make a negative decision, even if you're not aware at that moment of how upset you are.

The flip side of this is unconscious bias. Just as you can have a feeling that you're not aware of having, you also can have preferences that you don't realize you have. The simplest example is what psychologists call "implicit egotism," which is a really bad term for liking whatever is closest to you in some way or another. For example, people are 65% more likely to marry someone whose surname begins with the same initials as their own. When you tell people something like this, they tell you that's ridiculous, and how do they try to disprove it? They say something like, "Well, my name's Zweig and my last name begins with a "Z" and my wife's surname doesn't begin with a Z." That doesn't work. Psychologists have looked at hundreds of thousands of data points and demonstrated very clearly that this is true, and that people named Dennis and Denise are much more likely to become dentists then you would expect by random chance. People named George are more likely to become a geoscientist then you would expect by chance alone. We all come with these strange, unconsciousness preferences. We don't think we think that way, but we do.

The best example I can give is in June I was making a speech about the book in Edinburgh, Scotland, and I was at one of the largest global equity managers in the world, and I put up a slide about these forms of unconscious bias. All the Scots in the room were chortling: They couldn't believe how stupid Americans are, and that anybody would actually do something like this was just beyond them. Then the chief investment officer of the firm said, "Well, what about ..." and he named a stock that this firm is heavily overweight in. It turned out the ticker for the firm they're overweight in matches the firm's own initials. He said, "I'm very glad that you pointed this out because I never would've realized it. We probably do have an unconscious bias and now we're aware of it. Now maybe if the time ever comes that we need to sell that stock, we can make a more objective decision."

So people do stuff like that all of the time, and I'm prepared to bet that if we did a survey of all equity fund managers within America and we simply found out the eye color of all the managers and we then went and looked at their portfolios, we would find that UPS is over-owned by brown-eyed managers and Jet Blue is over-owned by blue-eyed managers. I haven't done this research yet, but I am very confident that that hypothesis is a good one and this is something that investors need to be aware of: that active managers may think they are choosing stuff for one reason, but actually it's almost as if the choice has been made for them by unconscious biases they don't even realize they have.

Index Universe: Stock analysts frequently develop relationships with and visit the companies they cover. Do you think that familiarity makes them more predisposed to recommend it?

Zweig: Absolutely, no doubt about it. One of the oldest and best-documented quirks in human psychology is something called the halo effect, under which if you rate one quality or aspect of a person or thing, all your subsequent ratings of all the other aspects will be colored by the first one.

So if, for example, you were to rate me on a scale of one to five on how handsome I am—and I don't know whether that would be a one or a five—but once you rate how handsome I am, you can then later rate how intelligent I am, how articulate I am, how wealthy I am, how positive I am. All of those judgments will be skewed toward the initial judgment of how handsome I am. And by the way, that's true whether your rating was high or low. So if you said, "Well no, Jason isn't handsome at all," then I wouldn't be very articulate either and I wouldn't be very intelligent. If you said I'm very handsome, then you would be much more inclined to rate my intelligence higher, my overall presentation higher, all of those things.

One of the most amusing studies in this field comes from high school teachers where psychologists took an answer to an actual essay question written by a real high school student, and made hundreds of photocopies of it, and distributed them to real high school teachers with the student's name in the upper right-hand corner, and in some cases, the student was named David and in other cases he was named Hubert. In some cases she was named Lisa, and in other cases she was named Bertha. And David and Lisa on average got grades 10% higher then Hubert or Bertha, because having a nice name casts a halo over the quality of the work. And people are totally unaware of this. They don't realize that they're responding to a halo effect, but they do.

One thing that people who buy index funds can take a lot of comfort in is that by definition, an index fund should not be influenced by unconscious bias, and overall, that should be a good thing over the long run.

Index Universe: What do you think, as the author, are the most important advice or findings in the book that investors should really focus on?

Zweig: If I had to boil it all down to one thing, it's you need to be more mindful as an investor. That means you need to keep better records of your decisions; it means you need to be more introspective and more retrospective. You have to look back at how your decisions have worked in the past; you have to think more carefully about the decisions you're making in the present.

And I guess if I had to boil it all down to one rule, it would be if the market is open, your wallet should be closed, by which I would mean if you get the idea today, you should not actually do it until tomorrow. Because if you sleep on it, you may wake up the next morning and your mood may have changed, the data may have changed, you may just see things in a different light. And it's quite rare, unless you're a short term-trader, for anything significant to change overnight that would leave you worse off, but you might well make a much better decision if you'd just wait until the next day.

Comments

[Al Capital:]

I like the idea of Zweig's recently published book, which supports the broad approach to investor awareness we seek. We strongly support the use of decision trees in tracking individual investment evolution. If you like Zweig's book you'll enjoy these posts which refer to both individual and institutional investors:

mnrtrading.blogspot.co...

mnrtrading.blogspot.co...

2007 Nov 11 02:54 PM