Because of bugs in the way our brains work, it is easy to manipulate us.
For example, social proof is the well-known principle stating that many people will believe something if most other people believe it. And see this.
In other words, we have a herd instinct. So if marketers, advertisers or propagandists convince us that most people believe something (even if they actually don't), we'll tend to believe it too.
Psychiatrists and behavioral economists tell us that this is true with investing, as well. Our brains are hardwired to "follow the herd" of investors. Since most investors lose money playing the markets, you don't want to follow the herd.
A study by Barber and Odeon (Journal of Finance, 2000) shows that an average household with an account at a large discount brokerage firm underperforms by an average 15 basis points per month based on the "efficient market" model. This is based on gross returns before expenses. The study also found that the average individual investor would have been better off by not trading.
Indeed, many savvy traders speak of "trading against the dumb money", meaning trading against the majority of people who follow herd instincts and lose money.
In Mean Markets & Lizard Brains, former Goldman trader Terry Burnham says our primitive [or "lizard"] brain was designed to help our ancestors hunt for food, daily survival stuff.
But "by its very nature, investing requires us to be forward looking, to anticipate events. Our lizard brains, however, are designed to look backward. Thus, the lizard brain causes us to be optimistic at market peaks (after rises) and to be pessimistic at market bottoms (after falls)." So whether it's optimism or pessimism, greed or fear, your emotions do your investing, not reasoning and logic—and you can't trust them.
In an otherwise totally dark room, a small dot of light is shown on a wall, and after a few moments, the dot appears to move. This effect is entirely inside-the-head, and results from the complete lack of "frame of reference" for the movement. Three participants enter the dark room, and watch the light. It appears to move, and the participants are asked to estimate how far the dot of light moves. These estimates are made out loud, and with repeated trials, each group of three converges on an estimate. Some groups converged on a high estimate, some low, and some in-between. The critical finding is that groups found their own level, their own "social norm" of perception. This occurred naturally, without discussion or prompting.
When invited back individually a week later and tested alone in the dark room, participants replicated their original groups' estimates. This suggests that the influence of the group was informational rather than coercive; because they continued to perceive individually what they had as members of a group, Sherif concluded that they had internalized their original group's way of seeing the world. Because the phenomenon of the autokinetic effect is entirely a product of a person's own perceptual system, this study is evidence of how the social world pierces the person's skin, and affects the way they understand their own physical and psychological sensations.
There was a great article in SmartMoney magazine, "Outsmarting Your Brain:" Harvard Business School professor Max Bazerman was speaking to a conference of 75 Wall Street power-players, guys commanding six-to-seven figure incomes for managing your money.
Max opened by auctioning off a $100 bill. Simple rules: The highest bidder gets the $100 bill. And the second highest pays what he bid, but gets nothing. Forty hands quickly pushed the bidding to $95. Then a couple presumably rational hot-shots, an institutional money manager and a pension-fund trustee, broke the $100 barrier, after which both were guaranteed losers.
Imagine the insanity: Two of America's financial geniuses caught up in a hotly contested duel, pushing the bids up, up, up … to $465!
That's right, the winner bid $465—for a $100 bill!
If you've ever doubted that investors are controlled by an irrational rat brain, the professor adds this scary observation: "I've played this game perhaps 600 times, and I've never seen the bidding stop below $100." Yikes! It turns out that the best-and-brightest managing the $10 trillion mutual fund industry are just as irrational as the rest of America's 95 million average folks who trust them with their money. The blind are leading the blind. We are all playing the stock market game like rats and lizards chasing around in a maze for cheese … while telling ourselves we're rational.
If we hold on to our investing beliefs even when we receive evidence showing that our strategies are wrong, we'll lose money.
The bottom line is that investors, consumers and citizens have no chance - and will become easy prey to those who are trying to sell us snake oil - unless we arm ourselves with a basic understanding of how our brains work.
There's a whole field called behavioral economics, which looks at social, cognitive and emotional factors in understanding the economic decisions of individuals and institutions performing economic functions, including consumers, borrowers and investors. The more you study behavioral economics, the less of any easy mark you'll be for bad investing decisions and snake oil salesmen.
Powerful stuff here George...this is a well written article on a very important subject.
it is how We the People of the planet have been led by lies from those who have understood how this principle works. Thanks George for all you do to educate and enlighten.
Denial. It's not just a river in Egypt.
How exactly have we've managed to survive this long as a species?
A few years ago, I played around in the forex gambling market and read a book called Trading In the Zone. It reinforces what you are saying in this post. What we perceive to be reality is not always reality.
Over at Bill Black's site today, there's this article that points out that all this austerity nonsense is just that...nonsense. Destructive nonsense. The economists of today (nearly all of whom missed the boat on this recession) have fallen prey to what you describe, this herd mentality. They are still stuck in gold standard thinking even though we've been off of it since the Nixon days. As your article suggests, slowly, one by one, economists are starting to realize how wrong they've been. Greenspan, Krugman, The Bernank all have started to question the conventional wisdom. Slowly, they are realizing what Mosler calls the 7 deadly innocent frauds is fact.
Sadly, this doesn't change things now, when we need it most.
Government needs to control aggregate spending to sustain full employment, either through reducing taxes on the middle class or increasing spending on infrastructure or both. Until that time, until people say "Enough!", we will continue to suffer needless pain while income inequality grows worse. Let's hope the herd changes direction soon because in the end, concentrated wealth destroys democracy.
1. Our notion of "money"
2. Our notion of "government"
Our current systems need to crash and burn and be re-built. Good luck everyone. Nature and the Universe is a mighty dictator and natural laws can never be broken because if they are the consequences are absolutely not avoidable.
How did Kyle Bass become a "top investor"?
I joined Mensa a year ago because I am largely immune to these type of social pressures and I thought maybe fellow citizens with High IQ's might also be likewise immune.
Nope - Mensans are just as susceptible to these pressures as other citizens.
From what I have read those who share my phenotype have a high tolerance for ambiguity and thus do not instinctively reinforce their own beliefs when confronted with contradictory data.
That being said - as an entrepreneur I have so far been a bit of a failure because I truly do not understand how the herd thinks - while my "normal" friend makes money hand over fist in - what seems to me to be - the most irrational of transactions.
Humans - you so crazy!
This is a great article. I've been convinced for some time that emotions always over ride intellect when fear is involved. The corporate press has mastered the art. It's the impenetrable wall that keeps the masses enslaved by their corporate masters. The question of our time is, how do we overcome the lizard brain reflex to free ourselves of emotional exploitation once and for all?