Monday, July 23, 2012

Driven to Trade

Here's a recent Wall Street Journal article by Jason Zweig. 

Zweig explores how much short-term thinking is part of our brain's fundamental wiring and the impact this can have on trading/investing behavior.

Why We're Driven to Trade

From the article: 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.

It turns out, the frontopolar cortex, an advanced reasoning center of the brain (located directly behind the forehead), is well-suited for finding patterns (and relentlessly attempts to do so) even when there is none. It will attempt to find patterns within randomness and see patterns that don't exist. So, at least somewhat oddly, it is literally the more advanced aspects of human intelligence that can get investors and traders into trouble. A new study (published in the Journal of Neuroscience) actually shows that those with a healthy frontopolar cortex often tried to outsmart a system that is essentially random while those with a damaged frontopolar cortex did not!

Unlike the other control groups (those that had a healthy frontopolar cortex), those with damage to this crucial reasoning center didn't tend to overweight recent random outcomes* and also didn't attempt to find non-existent patterns. If decision-making is heavily influenced by randomness interpreted as something with meaning, it's hard to imagine big misjudgments not being made. The article provides a good overview of the new study and reveals the way this tendency can adversely impact decision-making. More from the article:

...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.

Naturally, any trained response to this tendency necessarily starts with awareness, followed by procedures and routines that counteract the more adverse consequences, and plenty of ongoing discipline.

Check out the full articleIt goes on to suggest some ways to deal with this potential costly weakness. (Zweig's suggestions explicitly do not include the use of a hammer to the forehead. Thankfully, there are many solutions available more practical than that.)

Mostly, I think this gets back to simply knowing and staying within one's own limits while not confusing the illusion of control with actual control.


* What did healthy participants do? According to the article, they seemed to extrapolate "...their most recent experience into the future and choosing predominantly on that basis," - Nathaniel Daw, neuroscience professor at NYU
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