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Mind over Money: What Lab Rats Can Teach Us About Investing

June 2011

Lab Rat

“Our incorrigible search for patterns leads us to assume that order exists where it often doesn’t. Many of us believe, for example, that it’s possible to foresee where the market is heading or whether a particular stock will continue to rise. In reality, these things are far more random and unpredictable than we like to admit…[and] when it comes to investing, this incessant search for patterns causes more heartache than anything else.”

—Jason Zweig, Money magazine, November 1, 2000¹

We humans love good stories. We love finding patterns and figuring out why something happens. Sometimes this deeply human trait helps us make discoveries about ourselves and the world around us. But for investors, the endless search for patterns and explanations can do far more harm than good. The financial services industry knows this trait well and uses storytelling to sell all kinds of strange and expensive investments: “nuclear energy stocks will be hot because of global warming so buy this nuclear energy ETF!”…Oops, scratch that and try: “nuclear energy is over forever because of Japan so swap into this ‘ultra-short’ nuclear energy ETF!” The sad thing is that these dubious ‘stories’ are very effective sales tools for equally dubious products. Surprisingly, it’s often the smartest, best informed people who get hurt the most.

“That’s My Story and I’m Sticking to It”

“There are definitely times when normal people's high level of general intelligence makes them too smart for their own good,” says animal behaviorist, Temple Grandin. “My favorite example is the rats who beat the humans in a lever-pressing task.”²

The rats and humans had to look at a TV screen and press the lever anytime a dot appeared in the top half of the screen. [If the response was right, there was a reward; if wrong, there was no punishment.] The experimenter didn't tell the human subjects that's what they were supposed to do; they had to figure it out for themselves the same way the rats did.

The experiment was set up so that 70 percent of the time the dot was in the top of the screen. Since there wasn't any punishment for a wrong response, the smartest strategy was just to push the bar 100 percent of the time. That way you'd end up getting a reward 70 percent of the time, even though you didn't have a clue what the pattern was.

That's what the rats did. They just kept pressing the bar every time the screen changed.

But the humans never figured this out. They kept trying to come up with a rule, so sometimes they’d press the bar and sometimes they wouldn’t, trying to figure it out. Some of them thought they had come up with a rule…but they were deluded. They hadn’t come up with a rule at all, and the rats ended up with lots more rewards than the humans.

…[T]he conscious language part of the brain, always makes up a story to explain what’s going on. Normal people have an interpreter in their left brain that takes all the random, contradictory details of whatever they are doing…and smoothes everything out into one coherent story. If there are details that don’t fit, a lot of times they get edited out or revised. Some left brain stories can be so far off from reality that they sound like confabulations.

The interpreter probably got in the way on the lever pressing experiment. The human subjects kept trying to come up with a story about the dots, and when they did come up with a story, they stuck to it. Then the dot story kept them from realizing that they should just forget about the dots and press the lever every time the screen changed.

Revenge of the Talking Heads

To see this human trait in action, you need only turn on the financial news or pick up a copy of the Wall Street Journal. According to the media and assorted “experts”, the markets are never down just because there are more sellers than buyers, there is always An Explanation.

As author and market observer Jason Zweig muses:

“…[T]he financial markets are almost—though not quite—as random as those flashing lights. On CNBC and countless websites, investment strategists and other so-called experts scan the momentary twitches of the market and predict what will happen next. Far more often than they're right, they›re wrong—and [Dartmouth psychology professor George Wolford’s] discovery about the interpreter in our brains helps explain why. These pundits are examining a chaotic storm of data and refusing to concede that they can’t understand it. Instead, their interpreters drive them to believe they’ve identified patterns upon which they can base predictions about the future.

“Meanwhile, the interpreters in our own brains impel us to take these seers more seriously than their track records deserve. As Berkeley economist Matthew Rabin has pointed out, just a couple of accurate predictions on CNBC can make an analyst seem like an ace, because viewers have no way to sample the analyst’s entire (and probably mediocre) forecasting record. In the absence of a full sample, our interpreters take over and lead us to see the analyst’s latest calls as part of a pattern of success.”¹

How Smart Rats (and People) Can Win

The strategy that virtually ensures success in good markets and bad is also the simplest and cheapest: save money from every paycheck, putting some of it in cash for a rainy day or special expense, and investing some of it for the long term in broad low-cost stock index funds plus a bond fund or two.

As Zweig points out, investors who keep costs low (either through index funds or buy-and-hold stock and bond portfolios) outperform investors who trade too frequently or buy funds with high expenses. Diversification is the other principal that really works. Even in the worst moment of the credit crisis, cash and high quality bonds held their value, while broadly invested stock funds rebounded amazingly fast as the crisis eased; therefore investors who held both types of assets without trying to time purchases or sales were the ones most likely to win.

So take a lesson from the rats. When it come to investing, just keep pressing the lever and collecting the rewards.

¹Zweig, Jason (2001) The Trouble with Humans: Why rats and pigeons might make better investors than people do, Money magazine, Nov. 1, 2000

²Grandin, Temple & Johnson, Catherine (2005) Animals in Translation: Using the Mysteries of Autism to Decode Animal Behavior, Simon & Schuster p. 265.

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.

All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Past results are not indicative of future performance. Outside sources used in this article are believed but not guaranteed to be accurate. Examples provided are for illustrative purposes only and are not representative of intended results that a client should expect to achieve.