Dopamine and Pattern Seeking and Your Investments

Insights from Jason Zweig's Your Money and Your Brain:

Why do we continue to believe that we can outperform the market when research continually demonstrates that we cant?

The answer partly lies in pattern seeking behavior and dopamine.

Pattern recognition: humans have survived because the brain recognized simple patterns in nature. Unfortunately, the investment world is governed by acts of randomness, yet we want to believe we can see patterns and predict the future. This pattern seeking behavior is unconscious and uncontrollable and we humans will leap to conclusions. Such as, when we observe two or three years in a row of superior mutual fund performance, we tend to believe that a pattern is emerging and expect a fourth year of good performance.Study's show past mutual fund success is not the best predictor of future success, yet we cant help ourselves, we choose past winners.

Then there is dopamine. Dopamine is a chemical that sends energy throughout the brain and turns motivation into actions. Dopamine is so powerful that a rat will starve to death rather than turn away from dopamine. Lay an MRI scan of a cocaine addict about to get a fix next to that of a person who thinks he is about to win money and they are virtually the same. We also know this about dopamine and rewards: dopamine is strongest when a reward is unexpected. That getting what you expected does not produce dopamine, and if the expected reward does not show up then the dopamine dries up. We also know that if the reward is big enough, dopamine seems to have a memory. This last point is huge. Investors who have received a large reward will experience a dopamine release if a pattern similar to the winning pattern is observed. This may result in the investor taking actions that are not sound.

What can you do to help protect you from yourself:

1. Stop predicting the market.

2. Ask for evidence.

3. Face up to base rates - long term outcome using a large sample.

4. Realize that correlation is not causation - there is so much information available that marketers can prove anything. ask yourself how the results would be if the dates were different or if the assumptions were slightly different.

5. Take a break - give your brain time to re-group

6.Don't obsess -the more an investor watches his investment the likelier he is to trade and thus decrease his long term return.

Stanford study on older Investors

http://news.stanford.edu/news/2010/january25/older-investing-study-012810.html

A Stanford study indicates that brain noise in older people may lead to investing mistakes. This is another example of scientific technology helping us understand our investing behavior. More reason to follow some of the advise given in Jason Zweig's Your Money & Your Brain.

Your Money & Your Brain - Greed

In Chapter 3 of YM & YB Jason Zweig explores greed.

Did you know that you are more aroused when you anticipate a gain than when you actually realize the gain? The anticipation puts your reflexive brain into high alert.

Studies using MRI scans show that the part of the human brain that anticipates financial gain is the same area of the brain that experiences sexual pleasure and anticipates food. In fact, it is the expectation or arousal that is the main component of euphoria.

Your brain treats financial gain in the same manner it treats a broader group of rewards such as food, drink, shelter, safety, sex, drugs, and beautiful faces.

Our brains were designed to help us survive through the thrill of anticipation. It is the anticipation circuitry in our brains acting as a beacon of incentive that allow us to pursue longer term rewards. If we did not get pleasure from anticipation we would not be motivated to hold out long enough to earn them.

Anticipation also responds more to the size effect versus the probability of an event. In other words the, how big the reward has a stronger effect than a high probability reward. To quote Zweig: " when possibility is in the room, probability goes out the window"

Further more, we derive even more pleasure when we have a chance that we may lose money. Think about it, evolution has designed us to pay more attention to rewards when they are surrounded by risks.

So what can you do as an investor to manage your investing arousal (greed). Zweig says that the first thing to know is that your anticipation circuitry will get carried away. He gives some checks and balance ideas to help:

1. Be on the alert for the promise of a big score. Ask yourself : "what does this person know that others don't" or " Why is this person letting me in on this great investment secret" and never, never respond to an unsolicited offer.

2. Lock up your mad money and throw away the key. Put 90% of your stock money in low cost diversified index funds that own everything in the market and then put 10% into speculative investments. And, don't move money from your90% account into your speculative account.

3. Think twice - making an investment decision while you are aroused by the prospect of a big gain is a bad idea. Go distract yourself for a period of time and let your reflexive brain calm down .