Every so often, a fresh approach lifts financial researchers out of the rut of testing purported risk–return anomalies within the framework of rationality as defined by classical economists. Past examples of provocative new paths include chaos theory, neural networks, and behavioral finance. Financial journalist Jason Zweig’s Your Money and Your Brain: How the New Science of Neuroeconomics Can Help Make You Rich heralds another promising line of inquiry. Neuroeconomics, a mixture of neuroscience, economics, and psychology, interprets seemingly irrational investment decisions as biological phenomena.
A key technology with which neuroeconomists are breaking new ground is the scanning of brain activity via magnetic resonance imaging (MRI). Neuroscientists observe how certain stimuli fire up activity in portions of the brain responsible for feeling pain, registering disgust, housing long-term memory, and so on.
The ingenious experiments of neuroscientists make sense of behavior that suggests no logical thought process. For example, we know that 401(k) participants concentrate heavily in their employers’ shares. The overwhelming majority believe their own companies’ stocks are no riskier than the average stock, which in aggregate cannot be true. Economists see irrationality in this “home bias,” which is also manifested in dramatic overweighting of domestic stocks by investors around the world. Brain scans show that the amygdala, one of the brain’s fear centers, fires up when investors contemplate putting money into “foreign” stocks. Zweig portrays this response as an evolutionary adaptation to mankind’s early, physically perilous environment.
The author also offers an explanation for widely held beliefs about the market that lack empirical bases (e.g., October is the worst performing month, and stocks rise on Fridays and fall on Mondays). Apparently, a module in the brain’s left hemisphere induces humans to perceive patterns and causal relationships where none exists. This fallibility steers investors away from the simplest and best prediction strategy under such circumstances, namely, to predict the most frequently observed outcome in any given instance.
Zweig further recounts how a study of a 1972 diplomatic event produced the first clear diagnosis of “hindsight bias.”
Referring to the 2000 technology stock collapse, George Gilder, editor in chief of the Gilder Technology Report, insisted in 2002, “I knew that it was going to crash, I really did.” He had to admit, however, that his newsletter had never once warned investors of the impending bloodbath. Evidently, investment pundits as well as investors suffer from the faulty-memory affliction.
Turning to another syndrome, bipolar disorder, and its connection with economic behavior, Zweig writes:
Finding out that this mental illness can be traced to the same area of the brain that is activated by a string of financial gains isn’t just an intriguing way to explain the behavior of market lunatics like James J. Cramer of CNBC. It’s also alarming. For it suggests that when investors think they’re “on a roll,” when they’re filled with that sensation that they can see into the future and nothing can stop them, they can end up making the same kinds of mistakes that chronically manic patients make.
Zweig’s enthusiasm and zest for detail sparkle throughout this fascinating account. Moreover, in addition to interviewing leaders in the emerging scientific field, he subjected his own brain to MRI scanning.
Inevitably, however, even a book as meticulously researched as Your Money and Your Brain contains minor errors. For example, the author refers to Chinese ideographs as elements of “the Asian alphabet,” whereas they actually constitute a nonalphabetic, logographic writing system in which each character expresses a word part.
Happily, Zweig generally avoids the far more serious failing of many how-to investment books, which is to give only vagueness regarding implementation. In chapters on such investment phenomena as risk, fear, and regret, he provides the neuroscientific explanation and then recommends specific steps to avoid systematic errors. Among the advice given throughout the book are the following:
- Write out an investment policy statement and program your BlackBerry to remind yourself repeatedly not to violate it.
- As a reinforcement mechanism, change the password on your brokerage account to something like “dumpmylosers.”
- Rebalance your portfolio twice a year to maintain your desired asset-class mix.
- When you feel overwhelmed by risk, go for a walk, hit the gym, call a friend, play with your kids.
These are useful tips, but readers who take literally the book’s subtitle (How the New Science of Neuroeconomics Can Help Make You Rich) want to learn how to spot the stocks that will beat the market by a ton. Here, Zweig’s advice reverts to generalities—for example, “[T]ry to find a less obvious investment opportunity that most people have somehow overlooked.” The author also advises readers to focus on value stocks and on companies that refuse to provide earnings guidance. Both ideas have merit, but they will almost certainly not produce monumental gains.
Zweig discloses that he personally relies on index funds and urges readers to do likewise with 90 percent of their holdings. Few retail investors are interested, however, in purchasing a book that steadfastly refuses to encourage their fantasies of outperforming the averages. Accordingly, Your Money and Your Brain dangles the hope that by avoiding systematic cognitive errors, dabblers will succeed where most professional money managers fail. (It might be interesting to learn which sections of the brain respond to the words “new,” “science,” and “make you rich.”)
We can predict with high confidence that, collectively, the purchasers of Your Money and Your Brain will underperform no-load index funds by a margin at least as great as transaction costs (above the index funds’ typically low management fees) plus the price of the book. Over an extended period, this outcome will probably be true for nearly all who conscientiously follow the author’s advice.
On the positive side, Zweig’s readers might very well underperform the passive strategy by a smaller margin than they would if they had not read the book but gave free rein to their impulses. This result would represent a material benefit of the book, especially when coupled with the pleasure afforded by the author’s lively style. Additional satisfaction may be derived from the knowledge that one is reading a book destined to be a landmark in the popular finance literature.
—M.S.F.