- GETTING GOING
- October 25, 2006
Why Your 'Lizard Brain' Makes You A Bad Investor -- and How to Battle Back
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- JONATHAN CLEMENTS
We're pretty good at gathering berries and catching fish. But this mutual-fund thing is really messing us up.
Investors often make foolish financial decisions, and lots of folks are trying to figure out why. Specialists in behavioral finance have sketched out some of our more persistent mental mistakes. Neuroeconomics is looking at how the brain functions. Happiness researchers are trying to understand why our rising standard of living hasn't made us happier.
Now, some experts are turning to evolutionary psychology. Why do we make so many financial errors? Maybe, deep down, we're just cavemen and women.
Battling the past. It's helpful to think of our brains as having two parts, says Boston money manager Terry Burnham, author of "Mean Markets and Lizard Brains" and co-author of "Mean Genes."
There's the analytical part, which is the part that calculates that we need to save $542 a month for retirement. And then there's what Mr. Burnham calls the "lizard brain," which includes the instincts that helped our ancestors survive. And the lizard brain says it's better to consume, so let's take that $542 and go shopping.
As Mr. Burnham sees it, the problem is that the world has changed far faster than our lizard brains, so our instincts are out of step with modern financial life. Result? We make frequent financial mistakes -- including these five:
- We constantly strive for bigger paychecks, larger homes and fancier cars. Yet research indicates that these things won't make us much happier in the long run.
So why do we keep striving for more? Think about our ancestors. They didn't say, "We've got enough for dinner, let's knock off work early today." Instead, they survived and were able to reproduce because they had greater drive than those around them.
"There isn't necessarily a stop mechanism in us that says, 'Relax, you've got enough,' " notes Robert Trivers, an evolutionary biologist at Rutgers University in New Brunswick, N.J. "We've evolved to be maximizing machines."
- There's much handwringing over America's pitifully low savings rate. Perhaps, however, we can blame that on our ancestors as well.
After all, for them, the best way to save for the future was to consume now. By eating food when it was abundant, they could store the extra calories in their bodies, in the hope that this would carry them through any lean times that lay ahead.
"We have very little history of saving," Mr. Burnham says. "It should not be too surprising that we are terrible, on average, at this novel behavior." Because saving is such a new concept for us, some folks save too much -- and many save way too little.
- If you give people a choice between a small reward now and a larger reward in a few months, they'll typically opt for today's small reward. Partly, this reflects our tendency to regard consumption today as a form of savings.
But it may also reflect the lousy rates of return available to our ancestors. Forget earning a positive return on savings, like we can today. If our hunter-gatherer ancestors hung on to food, it might rot, it might get stolen, and they might not live long to enjoy it.
"There were a lot of things coming together to encourage us to consume now rather than to wait," says Cornell University economics professor Robert Frank, author of "Luxury Fever."
- As behavioral-finance experts have discovered, the pain we get from losing, say, $1,000 is far greater than the pleasure we get from gaining $1,000. This can cause us to shy away from stocks, especially if we focus too intently on short-term results.
Prof. Frank speculates that this loss aversion may have evolutionary roots. "Animals will fight viciously to protect territory that they hold, but they won't fight nearly as hard to extend their territory," he notes. The reason: Gaining territory won't benefit them much, but losing territory is a threat to their existence.
- For our ancestors to survive, they had to be good at spotting patterns, such as figuring out when and where they were likely to find wild animals, fish and other food.
But relying on past patterns can be a disaster if you are hunting for winners in today's markets. Just ask buyers of Internet stocks in early 2000 or purchasers of Florida condominiums in late 2005. They adopted winning strategies -- but the strategies stopped winning.
"In almost all other settings, it's good or neutral to mimic other people," Mr. Burnham says. "But in the financial markets, it's exactly the wrong thing to do. If something is too popular, it will be overpriced."
Faced with mistakes like the five listed above, what should we do? In many cases, the trick is to arrange our finances so our ancient instincts don't get a chance to foul things up. For some tips on how to do that, check out the accompanying chart.
"In the financial markets, the lizard brain is very damaging," Mr. Burnham warns. "You've got to find a way to decouple emotions from money."