Mean Markets and Lizard Brains Read online

  I interpret Paul Tudor Jones’s sign as a note to his lizard brain from his prefrontal cortex. Here is my interpretation: “Dear Mr. Lizard Brain, I know that you are built to be stubborn and proud. Although you like to behave that way, I (Mr. Prefrontal Cortex) prefer money. Therefore, I’m going to force you to take the profitable and not the proud path.”

  New ultimatum game research in the field of neuroeconomics shows us exactly what part of the brain operates to make people lose money. Professor Alan Sanfey and colleagues had people play the ultimatum game while their brains were scanned by an fMRI machine. People confronted with small offers ($1 or $2 out of $10) had greater brain activity in the bilateral anterior insula (not part of the prefrontal cortex), and subjects with higher activation levels in this area were more likely to reject these small offers.26

  These ultimatum game results provide us with direct, scientific evidence that parts of the human brain outside the prefrontal cortex push people down a path that costs them money. As I write this, we don’t have similar evidence for the brain location of most other economic biases, but we soon will. My prediction is that most “irrational” behavior will be found to be located outside the prefrontal cortex.

  Finally, in my own research, I have found that men who reject small ultimatum game offers have much higher levels of testosterone than those who accept.27 Often associated with muscle mass, testosterone plays a crucial role in the maintenance of dominance hierarchies. For example, I measured the testosterone levels of Howard Stern and others on his team. Howard, the socially dominant male in the group, had by far the highest testosterone. My friend Vinnie Favale, a big shot at CBS and a frequent guest on the show, had the second-highest testosterone level. Both Howard and Vinnie came in above younger men (Gary, KC, John) who are lower down in the show’s hierarchy.

  These results suggest that the lizard brain is not so crazy after all. In natural settings where people meet over and over again, it pays high-testosterone people to use conflict as a tactic to achieve their goals. Testosterone activates the lizard brain and makes some people more willing to be confrontational. In the unnatural setting of the laboratory, however, confrontation in the ultimatum game is costly, not beneficial. Like laboratories, financial markets are unnatural environments, and this explains why our instincts often cost us cash.

  What do you think happened to my offer of $10 out of $100? After learning that many people prefer no money to a small percentage, I feared all was lost. Furthermore, our group results showed that pride flowed strongly among these graduate students. Three of my fellow students had faced $10 offers, and two had rejected them. One person had even rejected $30 out of $100! By good chance, however, my puny offer of $10 had been accepted.

  Irrationality #2: Fear of Losses Causes Losses

  Consider your willingness to participate in the following risky gamble. A coin toss decides if you win or lose. If you lose, you pay $5. If you win, the jackpot is yours. Professor Kahneman asked people to tell him the smallest jackpot that would make this gamble worth the potential loss of $5.

  What is your answer? If your answer is more than $5, you hate losses. In fact, the average answer to this question is more than $10. Professor Kahneman interprets this to mean that people hate losses much more than we enjoy equal gains. We are not willing to lose $5 for the possibility of gaining just $5; we need a bigger jackpot to justify the risk.28

  Professor Kahneman calls our answers to this question, and the results from related research, “loss aversion.” Among all the findings that led to his Nobel Prize, loss aversion is one that Professor Kahneman rates as among the most significant. While hating to lose money might seem like a good thing, it can cause us to lose money.

  The infamous trader Nick Leeson exemplifies the troubles that loss aversion can cause. Leeson was the “Rogue Trader” who brought about the collapse of Barings Bank. Interestingly, Leeson himself wrote a book detailing his mistakes that was made into a movie starring Ewan McGregor.29 (I suppose I’d be tempted to commit some misdeeds if I could be sure to be portrayed by a dashing actor.)

  Barings Bank was one of Britain’s most prestigious financial institutions. It was destroyed when Leeson lost nearly 1 billion British pounds in a failed speculation. Although there are many reasons for the behavior, it is consistent with that caused by loss aversion.

  At first glance, loss aversion sounds rational. Who likes losing money? No one. But consider what happens when you have lost a little bit of money. Now, the strong hatred of losses creates perverse incentives. That is to take big, stupid risks with the possibility of avoiding the label of loser.

  Nick Leeson didn’t lose his billion pounds in one go. In fact, he made a financial bet that lost a relatively small amount of money. Rather than accept his small loss, Leeson dramatically increased his bet. He continued to add to his losing position, hoping that he could get back to even. In the end, it was precisely his hatred of losses that led him to massive and destructive losses.

  More than loss aversion caused the Nick Leeson blowup, but the general lesson is valid. Our hatred of losing money can push us toward taking bad risks, which in turn causes us to lose money.

  Irrationality #3: Finding Patterns in Random Walks

  One of B.F. Skinner’s most famous experiments created what he labeled “superstitious” pigeons.30 The experiment provided food to the pigeons at regular intervals. In many of Skinner’s experiments, he rewarded pigeons for particular acts. By reinforcing certain behaviors, Skinner was able to produce pigeons that could play ping-pong, or even pilot bombs. In his superstition experiment, however, Professor Skinner gave the pigeons food without attempting to reinforce any particular behavior. In fact, he gave the pigeons food “at regular intervals with no reference whatsoever to the bird’s behavior.”

  The outcome of this experiment was superstitious pigeons. Even though the food was given out on a fixed schedule, the pigeons attempted to make sense of the outcomes. (Of course, they didn’t really try to make sense of the outcomes; they have tiny brains and even tinier cortexes.) They did, however, change their behavior in ways that may seem quite rational. The pigeons tended to duplicate their own processes that preceded food. Skinner writes,

  One bird was conditioned to turn counter-clockwise about the cage, making two or three turns between reinforcements. Another repeatedly thrust its head into one of the upper corners of the cage. A third developed a “tossing” response, as if placing its head beneath an invisible bar and lifting it repeatedly. Two birds developed a pendulum motion of the head and body, in which the head was extended forward and swung from right to left with a sharp movement followed by a somewhat slower return.

  These pigeons were classic “stimulus response” machines. They replicated actions that led to good outcomes and avoided actions that led to bad outcomes. The actual result was quite amazing. Each pigeon developed its own superstitious behavior. These superstitious pigeons are crazy, because their outcome was not affected by their actions. Nevertheless, the small-brained creatures sought a pattern in their experimentally mad world. Professor Skinner concludes,

  The experiment might be said to demonstrate a sort of superstition. The bird behaves as if there were a causal relation between its behavior and the presentation of food, although such a relation is lacking.

  Surely, we humans are much smarter than these pigeons? Yes, with our large prefrontal cortexes we are indeed much smarter. Outside the prefrontal cortex of our brains less rational notions thrive in the lizard brain. We humans retain brain structures that are little different from the homologous parts of brains in other animals, even some that we might label as quite primitive. The lizard brain is an active, albeit often silent, actor in human decision making.

  Consider the following two sequences of heads (H) and tails (T):

  Sequence A: H-T-H-T-H-T-T-T-H-H-T-T-T-T-T-T-H-T-H-H

  Sequence B: T-H-H-T-T-H-T-H-H-T-H-H-T-H-H-T-T-H-T-T

  I just created A and B by using two
very different processes. I constructed one of the two sequences analytically. I produced the second sequence by flipping a quarter 20 times just now in my office. So one of the sequences was randomly generated by coin flips, while the other was constructed.

  So which sequence, A or B, is a random sequence of coin flips? Take a guess before I provide some hints.

  Let me tell you more details about the nonrandom process, and you’ll be able to figure it out. In the constructed sequence, I never allowed more than two consecutive heads or tails. Similarly, in this constructed version, I did not allow a strictly alternating sequence of heads, tails, heads to persist for more than three times.

  So sequence A, which contains a long string of consecutive tails is part of the random sequence. Sequence B is the nonrandom sequence. In experiments of this nature, people tend to pick the wrong sequence.31

  The point is that our lizard brains seek a logical pattern to illogical behavior. Stock prices have a large random component, yet we are all built to search for patterns in that noise. Many investment strategies are no better (and perhaps no less entertaining) than the dance moves of our superstitious pigeons.

  Irrational Nobel Prizes

  The academic battle over irrationality at the individual level is largely complete. There is overwhelming evidence that we do crazy things that defy the laws of logic. The 2002 Nobel Prize in economics, awarded jointly to Professor Daniel Kahneman and Professor Vernon Smith, is symbolic of the victory of those who believe that irrationality is a fundamental part of human nature. In the next chapter, we will see how these quirks and biases play out in financial areas.

  Before moving on, however, we must address what may be the mother of all irrationalities, that of self-control. In almost all models of rational behavior, people coolly trade off the future against the present. Should I, for example, pay more money up front on my mortgage and thereby buy myself a lower set of future payments? The single, correct answer is to weigh the cost against the benefit, using the appropriate formula.

  While this rational view of decision making is appropriate, and I actually use it from time to time, many other choices are made by far more whimsical processes.

  Consider the discussion that I have with my wife, Barbara, about four times a week. As we drive home in the evening, I suggest that we pull into the empty gas station and top off our tank. Unless the gas gauge is banging on empty, she argues against stopping. “Please, don’t stop. I’m really tired, and I need to get home right now.”

  The result of not topping up is that when we are about to leave on a trip, we need to go to the gas station. These trips often occur during busy afternoons and take much more time and stress than the late-night top off. On each night, however, Barbara looks forward to a blissful future with no time constraints and no fatigue.

  Our little game where I threaten to stop in the evening has taken a humorous turn analogous to the “cheese shop” game of Monty Python. That game is played as follows. One person, the customer, asks for a variety of cheese. The second person, the store owner, gives an excuse for why the cheese isn’t available (for example, “the cat just drank it” was one answer in the original skit for a particularly runny cheese). Each player has to come up with a unique cheese or excuse, and the game ends when one side runs out of new ideas.

  In our gasoline station variant, I propose new reasons why we have to stop and Barbara gives reasons why the present is a uniquely bad and inconvenient moment.

  The gasoline game is simply a trivial demonstration of a self-control problem. Most of our bad decisions involve an inappropriate trade-off between today and tomorrow. We know that we should work hard now and play later, but we are just so busy now.

  Behavioral economists have documented our self-control problems. In a variety of interesting settings we place too much weight on the present and too little on the future.32 We use our lizard brain when we ought employ our prefrontal cortex.

  Woody Allen says that the brain is his second favorite organ. As we have seen, our brains are not monolithic bastions of rationality. While we have a powerful prefrontal cortex with special analytic power, it has only limited ability to control the wild and powerful lizard brain.

  chapter three

  CRAZY WORLD Mean Markets and the New Science of Irrationality

  How Can a Market Be Mean?

  There’s a Wall Street adage that “markets move to frustrate the most people.” There is some suggestion that this is true. Contrarian lore tells us that when people are optimistic markets are likely to fall and pessimist sentiment is said to predict rallies. The more extreme the investors’ emotions, the more powerfully the market will move—but in the opposite direction of sentiment.

  A “mean market” is one in which people are systematically out of sync with opportunity. In a mean market, our lizard brain screams at us to buy just before a collapse and makes us want to sell in terror just before a rally. If markets did create such emotional cruelty, especially because it costs us cash, they would indeed be mean. Are markets really mean, moving to frustrate us systematically?

  There is one kind of market that can never be mean, and that is a rational market. To prove this point, try to be really wrong in predicting coin flips. For example, flip a coin 100 times and predict each flip. It is almost impossible to get significantly more than half wrong. This is true regardless of what system is used to predict the outcome of each flip—astrology, tips from friends, or always predicting heads. Because a fair coin is unpredictable, it is equally cruel (and kind) to all efforts at prediction.

  In a rational market, prices move like coin flips. In such a market, the chance of an up move in a short period of time should be almost exactly 50%. Furthermore, as with coin flips, nothing is supposed to be able to predict price moves. In such a market, all strategies to predict future price changes will be no better than chance. The bad news is that only those who are very lucky can do really well in a rational market. The good news is that it is also almost impossible to do really poorly in a rational market.

  Therefore, for markets to be mean they must be irrational. We tackle the issue of market rationality first, and then return to mean (and nice) markets.

  Are Markets Crazy?

  We know that people are crazy. In addition to the scientific evidence that has piled up over the last several decades and that we reviewed in Chapter 2, surely our daily experiences confirm, at least anecdotally, that we are just not as rational as we think we are (or at least not as rational as old-school economists assume).

  While the case against individual rationality is closed, this is not sufficient to prove that markets are irrational. Consider what happens when you put a bunch of crazy people together. Is the result more chaos, or can order emerge even from a group of irrational people? It turns out that both chaos and order are possible.

  In February 2004, hundreds of people were killed in a stampede outside of Mecca, Saudi Arabia. As part of the hajj, huge numbers of Muslim pilgrims were participating in a rite where each one throws a pebble at a historical pillar symbolizing the devil. The crowd crushed the victims as people in the back pressed forward to reach the pillar within the appropriate time frame for the ceremony. With its large crowds, the hajj has a history of deadly stampedes.

  Rock music fans can be almost religious in their fervor, and many concerts have turned deadly. In 1979, 11 fans were killed at the Who concert in Cincinnati. The causes of stampedes are often very minor; things turn deadly only when many individuals compound the original problem.

  A survivor of a stampede at a Pearl Jam concert that killed eight said, “Things were really great, and we wanted to move up.” As people moved closer to the stage, everything was fine until, “The pressure from behind was too great” and the desire to have a better view led to death. Similarly, a post-concert stampede in Belarus that killed 53 was caused by a hailstorm that made people rush to enter a metro station. In the dash for cover, a few young women in high heels fell and thus b
egan a deadly chain reaction.

  In the case of stampedes, groups of individuals, each one of whom may even be acting rationally, end up with very bad outcomes. The overall system works to magnify problems.

  In contrast, there are other situations in which the right guidance can turn a mob of unruly individuals into an efficient team. I think of one such example whenever I board an airplane. My standard experience is that the boarding process is extremely inefficient. As soon as allowed, everyone surges forward, rushing to stuff their bags into overhead compartments. Invariably, as I work my way to my seat, I have to wait for the aisle to clear.

  In contrast to this inefficient, clogged mess, I had one boarding experience that was almost magical. I was flying from Frankfurt, Germany, back to the United States on a flight that was extremely crowded. Rather than let us mob the plane, one of the gate agents organized an efficient boarding.

  With just a few moments of effort, this agent organized us so perfectly that passengers in row 56 were at the front of the boarding line, followed by those in row 55, and so forth. With this setup, there were no clogs in the aisles and hundreds of people boarded the plane effortlessly in just a few minutes. It was a miracle, and one that I wish for on every flight.