Our Brains and Investing History

I have currently being reading a wonderful book on the history of financial speculation:  Devil Take The Hindmost, A History of Financial Speculation, by Edward Chncellor.

While reading this book, I have been re-posting some chapter summaries from Jason Zweig's, Your Money & Your Brain, and I cant help but see the connection between how our brains drive us and the booms and busts we see in the investment cycle.

What we know is that making money creates a euphoria in our brain that is similar to a cocaine high. But when we start to lose, our lizard (reactive) brain takes over and we panic and flee. Neither state is rational.

What we have observed in the 300 years, or so, of market history is that financial markets tend to swing wildly. This is not new to the last few years. There is a rich history of boom and bust cycles. Investors drive up the price of everything; from tulips in Holland in the 1600's to on-line pet stores in the 1990's, all in an irrational frenzy of greed, then see it destroyed when some event trips their collective lizard brain into a protective panic state. As I read I will occasionally leave some quotes from the book that reflect how investment history repeats itself. It was already reapeating itself in the early 1800's. This from Lord Overtone in 1825:

"First we find it in a state of quiet, -next improvement,-growing confidence,-pressure,-prosperity,-excitement,-overtrading,-convulsions,-pressure,-stagnation,-distress,ending again in quiet."

Maybe Wall St, or government policies are not to blame for extreme fluctuations in investments, maybe our collective human brains are more to blame.

BEWARE: Your Lizard Brain Can Dominate Your Investing Decisions.

From Jason Zweig's Your Money and Your Brain:

The reflexive brain (or lizard brain) is that part of your brain that reacts to external stimuli, sometimes within a tenth of a second. It has developed to protect us from risk in our environment. It operates below the level of consciousness.

This is important to understand because your reflexive system is so fixated on change it is hard to focus on what remains constant. For example, we react to a 100 point drop in the Dow, but we don't keep it in context that it is only a 1% drop. Academic studies have shown that investors who focus on price levels outperform those who focus on price changes.

The other part of your brain: the reflective brain organizes information, categorizes it and tries to develop patterns. But, you cant depend on your reflective abilities, they are limited by your memory and the complexity of the problem.  Doctors and engineers as a group are poor investors because they try to find patterns and they miss the unforeseen event that renders their system useless.

The lizard brain dominance over the reflective brain can be observed in the average investors purchase of mutual funds. Most investors focus on the flashy factors when choosing a mutual fund: mutual fund manager, recent performance, reputation. They ignore fund expenses, which rigorous study has shown to be the most critical factor in predicting future performance.

Based on studies like the  annual Dalbar study of investor behavior, it is evident that our lizard brain dominates in most decisions for the average investor. 

It helps to have a trusted advisor, paid or unpaid with some understanding of human and market behaviors, to help you manage your natural reactions and stay true to your investment course.