Image Credit: Christophe Vorlet
By Jason Zweig | July 21, 2012 12:01 a.m. ET
With computerized traders that “hold” stocks for only a few seconds at a time and markets that can swing wildly in a matter of moments, long-term investing seems to be on the verge of extinction.
Perhaps this is inevitable. It turns out that short-term thinking is deeply embedded in the workings of the human brain. New research suggests that in order to avoid trading your accounts to death, you must counteract some of the very tendencies that make Homo sapiens the most intelligent of all species.
In a study published last month in the Journal of Neuroscience, researchers from California Institute of Technology, New York University and the University of Iowa looked at how people use past rewards to predict future payoffs.
Directly behind your forehead is a region of the brain known as the frontopolar cortex. Much larger in humans than in other primates, this area is critical to such advanced mental functions as memory, exploring new environments and making decisions about the future.
In the new study, the researchers wanted to see how the frontopolar cortex contributes to predicting rewards. So they compared people with damage to the frontopolar cortex against two control groups of healthy people and those with injuries elsewhere in the brain (but not the frontopolar cortex).
All the participants played a game in which they sampled four slot machines. They were free to play whichever machine they thought would give the biggest payoff. What they didn’t know was that the payoffs from each machine varied unpredictably.
The neuroscientists found that the two control groups tended to make their next bet based largely on how much a slot machine had paid off on the two most recent bets.
Almost as soon as the pattern of payoffs appeared to change, the participants in the control groups dumped one slot machine and jumped to the next. Although they did take longer-term results partly into account, “the healthy subjects appeared to be extrapolating their most recent experience into the future and choosing predominantly on that basis,” says Nathaniel Daw, a neuroscience professor at NYU who helped conduct the study.
The people with damage to the frontopolar cortex, however, “based their choices primarily on the cumulative reward history, not on the changes in the most recent outcomes,” he says.
Without the ability to tap into one of the brain’s most advanced reasoning centers, these people didn’t try to outsmart the system or to guess the next outcome of an essentially random process.
The experiment wasn’t designed explicitly to resemble a stock exchange, although its random structure does give it an uncanny similarity to real-world financial markets.
Among the mutual funds that were in the top half of performers in late 2009, according to Standard & Poor’s, only 49% of them still remained in the upper half a year later; a year after that, only 24% were left. That is just about what you would get if you flipped a coin. Trying to find the winners is futile if victory is determined largely by luck.
When confronted with the unpredictable, however, the frontopolar cortex refuses to admit defeat. It draws on all your computational abilities to search for patterns in random data.
In the absence of real patterns, it will detect illusory ones. And it will prompt you to act on them.
No wonder so many investors find it hard to muster the willpower to buy and hold a handful of investments for years at a time.
But if “buy and hold is dead,” as growing numbers of investors argue, it isn’t clear what else is alive. In the lousy markets of the past decade, various alternatives such as “tactical asset allocation” (or market timing), mathematical risk-reduction techniques and even plain old intuition haven’t worked out all that well, either.
Most of the folks who say buy and hold is dead don’t talk much about their long-term returns. Instead, they stress how they have done recently, a tactic that for many potential clients has the same irresistible appeal as the last couple of pulls on a slot machine.
The solution to short-term thinking isn’t to bash yourself in the forehead with a hammer, of course. But you can use your brainpower to your advantage.
Every investing decision you make should be the result of a deliberate process.
Start by creating a checklist of criteria that every stock or fund must meet before you buy or sell. Make sure you never buy or sell an investment exclusively because its price has gone up or down. In advance, list three reasons having nothing to do with price that would justify buying or selling.
After you sell, track the returns of those investments you sold, after you sold them, to see if they did better than whatever you bought in their place.
You don’t have to trade like mad just because the people who grab headlines hold stocks for a few minutes or seconds at a time. Knowing the limits of your knowledge is the highest form of intelligence.
Source: The Wall Street Journal, http://www.wsj.com/articles/SB10000872396390444097904577538924031591882
Chapter Four, “Prediction,” in Your Money and Your Brain