Mean Markets and Lizard Brains Page 2

  This book combines two of my passions: financial markets and the scientific study of human nature. I had my first taste of speculation back in the early 1980s. Because of asbestos litigation, the price of Johns Manville Corporation’s stock approached zero. I thought the low price was irrational so I bought some shares. The stock went up over 20% the day after I bought it; I sold my shares and pocketed several weeks’ worth of my salary.

  This trade had two effects. First, I acquired a taste for financial markets. I have been actively involved for more than 20 years, and have broadened my scope beyond buying stocks to include options, bonds, gold, currencies, and more. Second, I was puzzled by a market that produced opportunities like Manville almost for free (Warren Buffett also recognized the value and eventually bought the firm).1

  Years later, while I was getting my Ph.D. in the Harvard economics department, I found an intellectual home in the study of human nature. For more than a decade now, first as a graduate student and then as a Harvard economics professor, I have studied one central question: Why do people have problems in so many areas, ranging from food to sex to money? My search for an answer has taken interesting turns, including studying negotiators’ testosterone levels and living at a research station in Africa to learn from the behavior of wild chimpanzees.

  An important source of our problems, I have become convinced, is that we are built to solve the problems faced by our ancestors. Because modern industrialized society differs systematically from the world of our ancestors, we tend to get into trouble. In my first book, Mean Genes, Jay Phelan and I investigate how the human brain—shaped in the Pleistocene—contributes to obesity, drug addiction, and poverty.

  Mean Markets and Lizard Brains is a much more detailed look at one of the topics from Mean Genes. What mistakes do people tend to make in financial markets, and what can investors do to improve performance? Both book titles start with “mean” because each addresses areas of our lives where our instincts push us towards failure. It is a central feature of industrialized life that our passions conflict with our goals. Because of this, the world can sometimes seem mean.

  Markets can be mean to investors who buy when excited and sell when afraid. Because we are built for a very different world, our instincts tend to be out of sync with financial opportunity. Consequently, making money requires understanding and shackling that part of our brain that pushes us to make costly investing decisions. This “lizard brain,” which we all have lurking underneath the more cognitive parts of our brains, is great for finding food and shelter, but terrible at navigating markets.

  Mean Markets and Lizard Brains thus provides an answer to my question from two decades ago. Markets are irrational because of quirks in human nature. Those who understand this and harness the lizard brain can convert mean markets into money.

  TERRY BURNHAM

  Cambridge, MA

  January 2005

  Acknowledgments

  Jay Phelan and I have spent 10 years discussing and writing about the mismatch between Pleistocene brains and modern industrial societies. As is the case in such collaborations, most ideas are joint products. Beyond shared credit for the general concepts underlying Mean Markets and Lizard Brains, Jay deserves specific credit for aspects ranging from structure to style that are drawn from our coauthored book, Mean Genes.

  Many friends donated time reading drafts and providing crucial feedback. Doug Bodenstab has read and critiqued every chapter (some of them several times). Chris Corcoran has similarly been involved at each stage, bringing his physicist’s intuition to the book’s underlying mathematics. Jon Goldberg applied his common sense, depth of trading experience, and apt analogies from the world of golf. Jay Phelan asked the tough questions and often supplied the answers.

  In addition, others who read part of the book and made substantial contributions include: David Bear, Jeff Bodenstab, Peter Borish, Jane Burnham, Thomas and Marie Burnham, Judith Chapman, Adam Checchi, David Epstein, Brent Flewelling, Sue Flewelling, Lisa Gosselaar, Paul Greenberg, Brian Hare, Justin Holtzman, Matthew McIntyre, Michael Schwartz, Joel Smith, Martin Stapleton, Scott Stephens, and Sadek Wahba. Danielle Lake did a fantastic job of copyediting the manuscript.

  Pamela Van Giessen, my editor at Wiley, deserves fundamental credit. From conception through writing and publication, Pamela has provided the support and the vision to create a book that is both deeply practical and academically rigorous. And thank you to Peter Borish for introducing me to Pamela.

  Throughout every stage of the book’s development, my wife, Barbara Li Smith, has been a steadfast supporter and constantly pushed me to make the work fun. Her thoughtful advice and unselfish help made the book possible. And finally, our beautiful new baby, Charlotte Valentine, has provided daily inspiration.

  Thank you all.

  Terry

  chapter one

  INTRODUCTION Mean Markets and Lizard Brains

  Where Should We Invest Our Money?

  “Where should I invest my money?” So asked Adam, a former Harvard Business School student of mine. Soon after getting his MBA, Adam was working as an investment banker. His detailed knowledge of debt-laden companies had made him a bit gloomy about the economic situation. After hearing Adam’s views, I asked where he had invested his money. Given his dour outlook, I expressed surprise when Adam said he had 60% of his wealth invested in stocks. In response to my shocked look, he asked for my advice.

  Clearly, Adam thought he was being conservative with only 60% of his wealth in stocks. Hasn’t it been proven—over hundreds of years—that stocks provide the greatest long-term return? Shouldn’t a patient investor, particularly a young one, put almost everything in stocks?

  Maybe. Maybe not. Conventional approaches to answering Adam’s question are based on the old-school assumption that people are cool-headed decision makers and that financial markets are rational. Recently, a new school has arisen that embraces hot-blooded human emotions as a core feature of our world. The reality is that financial markets have always oscillated between manias and panics, but people have not been terrifically adept at identifying them in advance. The new “science of irrationality” provides a novel way to model the future and offers investors powerful tools for growing and protecting their wealth.

  Moving beyond simply describing financial irrationality, we find an underlying logic for costly behavior in what I label the “lizard brain”—an ancient, often unconscious thought process that exerts a powerful influence on us. This lizard brain has helped us reproduce, find food, and flourish, but it tends not to work so well when dealing with financial markets. The result? Mean markets that wreak havoc with our finances.

  We will use the new science of irrationality and an understanding of the lizard brain to evaluate bonds, stocks, and real estate. We will find that the current situation is almost a perfect storm designed to frustrate our financial plans, and this will lead to surprising answers to Adam’s question. In addition to learning where to invest, we will produce novel suggestions on how to invest. Beyond simply making more money, a goal of Mean Markets and Lizard Brains is to increase confidence and reduce financial stress.

  The Conventional Wisdom: Bonds Are for Wimps

  Adam works for a famous Wall Street investment bank. If he were to look to Wall Street for guidance on where to invest, he would find some simple advice. Buy stocks. Figure 1.1 shows the consensus of the leading Wall Street investment firms.

  Wall Street says to invest the bulk of our money into stocks. In addition, economists trumpet the high return on stocks. (“Bonds are for wimps” is a quotation of Harvard Professor Greg Mankiw, head of President Bush’s Council of Economic Advisors.1) Those of us who live on Main Street have heard the “buy stocks” message loudly and clearly. While only 5.7% of households owned mutual funds near the stock market bottom in 1980, the figure now sits near an all-time high of 50%.3 Furthermore, the most recent Federal Reserve Survey of Consumer Finances reports that stocks represent 56% of all Ameri
cans’ financial assets—a record high.4

  FIGURE 1.1 Bonds Are for Wimps (Wall Street’s Investment Advice)

  Source: Dow Jones Newswires, Wall Street financial strategists2

  So Adam’s decision to invest most of his money into stocks reflects both the conventional wisdom and common practice. But should we continue to buy stocks and confidently expect high rates of return?

  Wax On: The Science of Irrationality

  In The Karate Kid, Daniel (played by Ralph Macchio) moves to California and earns the hatred of a pack of teenage bullies. In self-defense, he seeks to learn karate from Mr. Miyagi, the apartment custodian. Daniel is puzzled, however, when his training consists of performing household chores. For example, he spends many hours polishing Mr. Miyagi’s cars using a particular “wax on, wax off” technique. In a frustrated confrontation with Mr. Miyagi, Daniel is surprised to find that the cleaning techniques are actually karate moves.

  Similarly, we answer Adam’s question by first addressing core principles and later applying them to bonds, stocks, and real estate. The conventional wisdom is based on a view that people are nearly perfect decision makers. Sane investors, the rational view suggests, would buy risky stocks only at prices low enough to promise a high return. Thus, the standard advice to buy stocks is based on the assumption that market prices are rational. If markets are crazy, however, then the “buy stocks for the long run” message might be wrong. To know where to invest, therefore, the first step is to investigate rationality.

  Are people really cool-headed robots who calmly evaluate financial opportunities according to the maximizing rules of calculus? There is one place in the world where people do act this way; that place is economic theory. The standard assumption in economics is that people make such good decisions that our choices are labeled as “optimal.” Conventional investment advice is based on this underlying belief that people and financial markets are rational.

  In the real world, however, people are far from rational. Perhaps my own most poignant lesson came in a battle with a wedding photographer. After taking the pictures of our wedding, Juli the photographer would not give us our pictures. I appealed to Juli’s morality and to her self-interest with a variety of sophisticated tactics to get our photos. I even offered to pay additional money. To all these rational tactics, she never responded. After Juli spent some time in jail, however, she relented and gave us our negatives. Was her behavior rational? No. She gained nothing from her obstinacy and suffered severe penalties. Is such irrational behavior common? Yes.

  People are crazy. While we all know this, the investigation of the economic implications of irrationality began in earnest only in the late 1970s. Professor Daniel Kahneman, along with the deceased Professor Amos Tversky, began the rigorous documentation of human decision-making errors. In 2002, Professor Kahneman shared the Nobel Prize in Economics for this new scientific approach to irrationality with my graduate school advisor, Professor Vernon Smith.

  Investment advice has not kept up with cutting-edge intellectual developments. While the science of irrationality has grown up, the conventional wisdom still provides investment advice based on outdated theories of sane people and rational markets.

  Wax Off: Meet the Lizard Brain

  Behavioral economists have proven that our financial decisions are often irrational. The obvious question is, why have we been built to be so bad at such important tasks? To find the underlying rationale for irrational behavior (which turns out not to be so crazy in some respects), we have to look beyond standard behavioral approaches to some groundbreaking work in other fields.

  An important source of our troubles lies in the discord between our modern world and that of our ancestors. We are built to solve ancestral problems, and sometimes this gets us into trouble. Some of the most compelling examples of these insights come from medicine.

  Consider that babies who breast-feed exclusively need to take vitamin D supplements or risk serious health consequences.5 Nothing would seem to be more natural than to feed mother’s milk to a baby. Why are we built to cause sickness in our children? The answer is that we (both as adults and as babies) manufacture vitamin D when we are hit by sunlight. People who spend a lot of time outdoors, particularly in places with strong sunlight, make plenty of vitamin D. The babies of our ancestors got enough outdoor sunlight to be healthy. Many babies (and their moms) today, however, stay indoors or out of direct sunlight to avoid skin cancer, so our natural-born system doesn’t work. Thus, our babies get sick because we live differently from our ancestors.

  A similar logic is found in the prevention of heart disease. Men, in particular, are told to take an aspirin a day to thin blood, reducing the risk of heart attacks.6 Why don’t we produce blood that has the correct viscosity? The answer is that “thick” blood heals wounds rapidly. Our ancestors had frequent wounds, and most died too young to worry about heart disease. Thus, our blood is too thick for us because it is built to protect us from the ravages of an ancient world where people were often wounded and died young.

  So what does all this have to do with our financial decisions? Our brains, like our bodies, reflect the world of our ancestors. In particular, our lizard brains are pattern-seeking, backward-looking systems that allowed us to forage successfully for food and repeat successful behaviors. This system helped our ancestors survive and reproduce, but financial markets punish such backward-looking decisions. Consequently, our lizard brains tend to make us buy at market tops and sell at market bottoms.

  In Pitch Black, a sci-fi film featuring Vin Diesel, a group of intergalactic travelers crash on an ominous planet. They soon learn that the interior of the planet is filled with vicious creatures. The good news is that the creatures cannot arise in daylight, and because the planet has multiple suns, eclipses are many years apart. The bad news is that the next eclipse, with its consequent destruction, is coming in just a few hours.

  Similarly, there is good news and bad news for the role of the lizard brain in our financial decisions. The good news is that the lizard brain’s influence on our financial decisions is disastrous only in some particular and rare circumstances. The bad news is that we are living in one of those dangerous environments today. For the last several decades, we have enjoyed the benefits of several powerful, but unsustainable, financial trends. Our backward-looking lizard brain is most likely to impoverish us in precisely these sorts of environments. In a sense, we now face the meanest of financial markets, almost cruelly set up to frustrate and to cost us money.

  Just as we can live longer by understanding the basis of our medical problems, we can make more money by understanding and taming the lizard brain.

  How to Profit from the New Science of Irrationality

  In The Karate Kid, our hero soon stops waxing cars and begins competing. Similarly, the focus of this book starts with irrationality, but then quickly applies the lessons to the most important issues facing investors—the health of the economy, budget deficits, productivity, savings, inflation, the trade deficit, bonds, mortgages, stocks, and real estate.

  The first section summarizes the key findings of the science of irrationality. We review the evidence that even the smartest of people make systematic mistakes. These individual quirks create manias and panics, and markets that are far from rational.

  The second section is a primer on the economy, inflation, and the value of the U.S. dollar. Will U.S. budget deficits hurt the economy? Can the productivity revolution allow us to be richer and lead better lives? How will the decline in the U.S. dollar affect investors? When will the dollar decline end? Is the Federal Reserve creating inflation? Why would anyone be worried by prices being too low?

  In the third section, we apply our analysis to the most important investment decisions we face. Are interest rates going to rise substantially? Has the bull market in stocks returned, or is the early twenty-first century stock market rally a trap? Is there a housing bubble?

  Our analysis culminates in the final section that
provides specific investment advice. An understanding of the lizard brain provides a timeless blueprint for effective and low-stress investing. Furthermore, we reach a timely and unexpected answer to Adam’s question on where to invest.

  The lizard brain will be a leading character throughout our journey. Are there really $100 bills on the financial sidewalk? The answer is yes, but they are found in financial blind spots created by the lizard brain. The new science of irrationality shows us how to see into those blind spots so we can grab those $100 bills and improve our investment returns with less stress.

  PART ONE

  The New Science of Irrationality

  The central question of Mean Markets and Lizard Brains is, “Where should I invest my money?” The conventional answer is that those who seek high returns must take high risk. For a patient investor with some tolerance for risk, conventional wisdom says to buy stocks.