Your Money & Your Brain - Confidence

What I love about this book is that its findings and applications apply to many areas in life. At a later date, I will post a blog on how these same principles apply to social policy and human motivation.

In Chapter five, Zweig discusses the dangers of inherit in confidence. We as humans have a tendency to believe that we are better looking, smarter, funnier etc. than we really are. Studies show that we rate ourselves consistently above average on any item measured. How can that be? by definition we all cant be above average. This is not a bad thing, if we didn't have confidence we we would never take risks.

Unfortunately, in investing, this overconfidence can lead to underperformance:

* We believe we are smarter than the collective market. Surveyed investors believe they will outperform the market by 1.5 percentage points. Mutual fund investors believe the funds they pick will outperform the market. Again, how can we all beat the market?

* We put too much faith in what is familiar. This "home bias" leads to too little allocated to foreign investments and too much invested in our own companies stock (think Enron). Brain scans of investors show that when considering placing money in foreign markets their amygdala (brains fear center) kicks in. Staying close to home feels safer.

* We think we have more control than we do.

* We have "hindsight' bias. We think we predicted what occurred, which leads us to think we can predict the future.

* We hate to admit that we don't know something. Ironically, this means we are overconfident in our abilities to overcome our overconfidence.

A great point in the chapter is Zweigs discussion of "illusion of control". More than any other activity except sports and gambling this effect exists in investing. Illusion of control exists when:

* activity appears partly random

* there are choices

* involves competition

* can be practiced

* requires effort

* feels familiar

This results in what Zweig calls the Colonel Klink illusion. You think you are in control. But you are not.

What can we do to protect ourselves:

1. You need to say "i dont know" then learn more.

2. Discount your expectations by 25% before you act.

3. Write down why you made the decision you did. Write out "i think this investment will go up because_______________."

4. Learn what works by tracking what doesn't

5. Don' t just buy what you know and don't get stuck on your co.'s stock.

6. Diversification is the best defense.

This last point is huge. I have studied investing for the last 25 years, I am convinced that there is no better investing strategy other than building a well diversified portfolio that is appropriate for your capacity for risk and doing little, other than re-balancing it annually, or adjusting for changes in life circumstance.

Social Security Information

The following link is a very good tool for anyone approaching retirement age and trying to decide when to start social security benefits:

http://www.fpajournal.org/CurrentIssue/TableofContents/SocialSecurityWhentoStartBenefits/

Nice overview of Efficient Market Theory

This brief article is a nice summary of the Efficient Market Theory (EMT). Read this and you will gain a good understanding on the debate that is currently going on in the investing world.

The EMT is the theoretical underpinnings that support indexing and diversification.

http://researchmag.com/Issues/2010/April-1-2010/Pages/Efficiently-Controversial.aspx

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 .

Your Money & Your Brain - some advice

Chapter two of YM & YB explains how the reflexive and reflective brain operates. It also starts to give practical recommendations for investors. I will review a few in this post:

1. When it comes to trust, go with your gut. When choosing an advisor don't get caught up in the alphabet soup of credentials. Research a potential advisor by using www.nasaa.org or www.advisorinfo.sec.gov. These sites will let you know about discipline issues that may exist. Once you find a credentialed adviser go with somebody you trust. If you have an unsure feeling, trust your gut and keep looking.

2. "Ask another question" about your investment decisions. Ask yourself the following questions when you are about to make an investment decision: "how do I know," "do I need more information," "how would I advise a friend."

3. Conquer you senses with common sense: don't get caught up in the marketing. Remember the Wall Street marketing machine are appealing to your reflexive systems feelings of comfort and security. When making decisions compare the product to a benchmark. Also, ask how it fits with your total investment strategy.

4 Use rules, stay with you plan unless you have reason to deviate.

5. Count to ten. Your reflexive brain wants to immediately respond to current situations. When your emotions or the environment are running high. Stop, slow sown and evaluate the situation according to your rules and the rational evidence you may have at hand.

6. Do your homework so you have the rational info to anchor yourself with. Read a little about market history, portfolio development and the investment you are about to purchase or sell. Warren Buffet studied the financial of Anheuser-Busch for 25 years before he felt it was cheap enough to buy.