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January 2007   Volume 3   Issue 19

Psyching out the Market

Imagine you’re going out to dinner with some friends, and you are deciding between two restaurants. One has a half hour wait, while the other restaurant right next to it, which looks identical, is empty. Given the choice, most people will decide to put their name on the waiting list out of concern that the crowd must know something about the empty restaurant next door.

The challenge of any investor is to find the quality empty restaurant before the rest of the crowd rushes in. The goal, in other words, is to find great buys when the crowd hates them, and sell when the crowd buys them.

As simple as it sounds, our brains have evolved thinking like the crowd, because that provided increased safety to our ancestors. In fact, our brains—as remarkable as they are—have developed all sorts of responses that made life easier for the hunter-gatherer and make our investing lives difficult.

For our hunter-gatherer ancestors, anybody who failed to predict where food could be found would have starved to death. But anybody who correctly gambled on finding some prey or supply of food would have been a hero.

And our brains have evolved to reward the sort of risk taking that enhanced survival, according to neurophysiologists. When a hunter would set out after a large prey, his brain would release a chemical called dopamine that would give him a natural high to keep him seeking the meat needed for survival. It’s the release of dopamine after an unexpected or even an imagined reward that makes humans willing to take big risks.

But what was good for early hunters isn’t necessarily good for the investor. Hunter-gatherers needed lightning fast warning systems and reflexive responses to sudden dangers. Investors face challenges of discerning long-term patterns or focusing on many different factors at the same time.

Because of this, thinking like a good investor means ignoring some of the brain functions we spent millions of years developing.

The Joy of Anticipation

Dopamine still offers rewards, but it doesn’t always reward the best investor behavior. The chemicals that gave us the thrill of the hunt now trick people into gambling on the lottery or investing large sums into penny stocks in hopes of finding the next fortune builder.

Researcher Jason Zweig who is a senior writer for Money magazine, has interviewed a number of prominent neurophysiologists at universities and institutions all around the world and the consensus is that the human brain loves longshots. The less likely or predictable the external goal, the more dopamine floods the brain to provide a sense of comfort and well-being.

There’s evidence to suggest that thousands of investors get a dopamine high every day just sitting down in front of their computers, buying and selling stocks, and anticipating the profit it will bring.

Unfortunately, this soft euphoria can be addictive, even though it isn’t productive.

Fight or Flight

We seek and anticipate gains when the market is doing well, and panic when it is doing poorly.

Using MRI scans, neuroscientists have been able to see what occurs in the fight or flight region of the human brain an area of the brain known as the amygdala. These scientists conduct experiments where people are confronted with the prospect of a major loss or gain. A potential gain has a decent effect on the amygdala, but nearly as strong an effect as a potential loss. At the prospect of loss, the amygdala lights up like a firefly.

As a result, market panics and rapid declines occur far more frequently than raging bull markets, because thousands, if not millions of people, are responding to the lightning fast warning system in their brains. Clearly, dumping all of your stocks just because the Dow is dropping or there’s terrible news can be extremely costly.

Going Against the Crowd

Years ago, when the Japanese stock and real estate bubbles were at their height, a common belief among analysts was that nobody was in danger if we crossed on a red light together. It was painfully obvious that stocks and real estate were overvalued, but because the crowd continued herding into these investments—spurred on by the anticipation of profits—banks, lenders, and everyone else just assumed these overvalued investments would safely rise.

We know now that didn’t happen. The prices got so out of hand for Japanese real estate that in Tokyo, one of the most crowded areas in the world, real estate values today are roughly half of what they were 15 years ago.

Regardless of where the market is headed, crowds overprice or underprice stocks, bonds and properties all the time because they listen to their emotions, and that leaves dozens of opportunities for the investor who can learn to take advantage of these mistakes.

Some of the greatest investors, including many self-made billionaires, admit that they like to have an uncomfortable feeling in the pit of their stomach when they make the first purchase of something that’s extremely undervalued.

Instead of a comforting release of dopamine, these investors look for the butterflies that tell them they are truly going against the crowd.

A Few Unloved Stocks for 2007:

The Fallen Angels Funds

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Disclaimer
The opinions expressed are those of Gabriel Wisdom and Michael Moore and do not necessarily reflect the opinions of American Money Management, LLC (AMM), an SEC registered investment advisor who serves as portfolio manager to private accounts as well as to mutual funds. Clients of AMM, Mr. Wisdom, Mr. Moore, employees of AMM, and mutual funds AMM manages may buy or sell investments mentioned without prior notice. This newsletter should not be considered investment advice. The opinions expressed do not constitute a recommendation to buy or sell securities. Investing involves risks, and you should consult your own investment advisor, attorney, or accountant before investing in anything. Current stock quotes are obtained at http://finance.yahoo.com. Prices are as of the close of the market on the previous day of trading.

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