By Jason Zweig | July 24, 2012 7:00 am ET
Image credit: “Fool,” (detail), Francesco da Castello (1481), MS G.7, fol. 18r, The Morgan Library
My column this past weekend explored the odd paradox that the frontopolar cortex – an advanced part of the brain, critical to long-term planning, that appears to help make Homo sapiens the most intelligent of all species – may also contribute to short-term investing behavior.
According to new research, this area of the “rational” brain forms expectations of future rewards based largely on how the most recent couple of bets paid off. We don’t ignore the long term completely, but it turns out that we weight the short term more heavily than we should – especially in environments (like the financial markets) where the immediate feedback is likely to be random.
In short, the same abilities that make us smart at many things may make us stupid when it comes to investing.
For quick confirmation, look no further than this recent study, which analyzed the accounts of nearly 1.5 million 401(k) investors and found that many of them switch back and forth from stocks to bonds and other “safe” accounts based on data covering very short periods.
Because many of these investors are investing for 20, 30 or 40 years into the future, this short-term behavior – what the researchers call “feedback trading” – makes little to no sense. It imposes trading costs on the remaining investors in the underlying mutual funds, it requires at least some monitoring, and in the long run it is unlikely to raise returns or reduce risk.
You might argue that the long run is nothing but a string of short runs put together, or that you can get peace of mind by limiting your risk to fluctuating markets when prices fall, or that major new information should immediately be factored into even your longest-term decision-making. But many of these 401(k) investors were overhauling their portfolios based entirely on how markets performed on the very same day.
Anyone dumping an asset based on a one-day fall in its value is also prone to buy it based on a one-day surge in its price. Chasing the hot dot like that every day will tire you out long before you can retire.
Chapter Four, “Prediction,” in Your Money and Your Brain