Want to become a better investor?
Get brain damage.
That's the finding of a rather
unusual study by researchers from Carnegie Mellon University, the Stanford Graduate School of Business and the University of Iowa. It was published in
in June, and its conclusions were reported in
The Wall Street Journal
But don't start playing football without a helmet just yet: It's not any type of brain damage that helped investors in the study, but rather, a very specific form: a site-specific lesion (a kind of tissue damage) in the region of the brain in charge of controlling emotions.
The investors who have these lesions are unable to experience fear or anxiety. It turns out that lacking the emotionality ordinary investors exhibit leads to better investment decisions. It is not at all surprising that the emotionally limited investors outperformed their peers. We know from experience that when investors allow their emotions to unduly influence them, they tend to make foolish -- and expensive -- decisions.
It was not simply a lack of emotions that caused the improvement in performance in the study. When presented with a high risk, higher return possibility, the participants with these site-specific lesions lacked the fear the other investors had. The more emotional participants failed to capitalize on these opportunities. In other words, they were greedy at the right time. That accounted for nearly all the difference in their performances.
But the basic lesson from the study is simple: Investors who learn how their emotions impact their investing -- and can get them under control -- stand to significantly improve their returns.
Emotions Undercut Performance
previously, human beings just weren't built for capital markets. We have numerous design flaws that work against us in the investment process. But once you become aware of
they impact your thinking, you have a chance at avoiding some of the more damaging behaviors. At the very least, you can try to work around some of these hard-wired foibles.
There are three broad categories in which emotions work against the investor: ego, flawed analyses and the derailed plan. Let's look at some examples within each category.
The ego issue may be subtler than you would expect; certainly, a prideful trader who is unable to admit he or she is wrong ends up holding losing positions longer than he or she should. That's an expensive flaw, and it's why investors who
anticipate being wrong can more quickly -- and therefore less expensively -- cut losses.
But ego has an insidious impact on our analytical abilities as well. It is a subtle form of bias inherent in our thinking process. Ego is why we selectively perceive data, why we emphasize that which confirms our prior views. It helps us ignore new data that may contradict our preconceived notions. It even facilitates our forgetting information that is inapposite to our viewpoint.
That's a pretty powerful analytical flaw hardwired into our brains, damaged or not.
We have other analytical flaws that are emotionally related. Why do we over-emphasize the most recent data point in a series? Each new economic report generates a giddy excitement, almost as breathless as a child the night before Christmas. When we consider the volatility of these data series, and the hedonic adjustments each one must suffer through, it's apparent that they are of more limited individual value. Smart traders focus on the trend of these releases, and not any one data point.
We might have enjoyed 10 good GDP reports in a row, but let one bad one slide out and we become fearful and nervous. Or consider the opposite: we've just had over two years of data suggesting that inflation is resurgent, yet the first monthly report (June 2005) showing CPI and PPI as flat caused the Greek chorus to sing that inflation has been defeated in our lifetime. That's hardly the case.
Then, there are fear and greed. These are the best-known market emotions, and they cause all sorts of problems for investors. Our passions have an unfortunate tendency of getting the better of us -- and at exactly the worst possible moment, too. It's not merely chasing hot stocks at the top or getting panicked out at the bottom that's so problematic: It's the impulsive destruction of our investment strategy and long-term plan.
Decisions vs. Decision Making
One of the reasons that emotionally restricted investors have an advantage over everyone else is that they eliminate emotional decisions. It's a battle between impulsive choices, vs. a process for making rational decisions.
Without the tug of adrenaline and dopamine, you can stick to your original investing plan. That's actually the key problem with biochemical or hormonal decision-making: It's not that the decisions are necessarily so bad -- although they often are -- but even more significant, they derail your original investment plan.
As investors, you need a plan that allows you to save an adequate amount of money for retirement. We'll delve into this further in a future column but, suffice to say, the biggest problem with fear and greed is that in the blink of an endorphin, they can derail a well-thought strategy.
Think of this in terms of food: Imagine you are on a carefully crafted diet. You eat only healthful meals from a list of ingredients that have a good balance of carbohydrates and protein, with a limited amount of fat. Now consider an impulsive snack. What are the odds that this cheat will fit into your planned diet?
That's the key problem with emotional decision-making. When carefully designed strategies are supplanted by an impulsive choice, you have a recipe for poor performance.
As Malcolm Gladwell's best-selling book
Blink: The Power of Thinking Without Thinking
makes clear, unless you are an expert with decades of experience, instantaneous reactions can often have disastrous consequences.
To be sure, the study has an inherent bias in it: The experiment was designed so "risk-taking was the most advantageous behavior." The less-fearful participants made higher return investment decisions. In reality, people have a tendency toward risk-averse economic decision-making.
That aside, there are important lessons to be learned:
Do not allow your emotions to derail you from your plan;
Learn when risk-taking is an appropriate course of action;
It's not just the decisions, but the decision-making process that you can control.
Short of brain damage, there are ways to control the impact our emotions have on us as investors. Investors who do that achieve much better returns.
Barry Ritholtz is chief market strategist for Maxim Group, where his research and market analysis are used by the firm's portfolio managers and clients in the U.S., Europe and Japan. He also publishes The Big Picture, his macro perspectives on the economy and geopolitics, entertainment and technology industries, and is a member of the board of directors of Burst.com, a streaming media software company. At the time of publication, Ritholtz had no position in any securities mentioned in this column, although holdings can change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Ritholtz appreciates your feedback;
to send him an email.