How Your Brain Views the Stock Market
Investors today view the stock market in two different ways – either they think they can outperform it using careful thinking and rational strategies, or they believe they don’t know what they’re doing and are better off letting others invest their money for them.
And more often than you’re apt to believe, an individual investor can hold both views. But as silly as that may sound, the truth is that both views can be true. It’s possible, even likely, that when we look at the stock market we believe we can outperform it while at the same time also believe we don’t know what we’re doing.
How can this be? Like Schrodinger’s cat, it’s sometimes difficult to make sense of it.
The reality is, however, we have two ways of thinking. Our brain is wired to be both deliberative and intuitive. Intuitive thinking, equated with emotions, works quickly and automatically. Most of the time we’re not cognizant of how it works because it works in the background without us directly thinking about it.
This is the reason we jump into the stock market when prices are rising rapidly and everyone around us is making money hand over fist. We don’t want to be the only ones left out and our emotional thinking, using past experiences of being left out of something coupled with the heuristics we use to process these experiences, makes us do whatever is necessary, logical or not, in order to ensure we’re running with the crowd.
Unfortunately these actions usually end up costing us lots of money.
Now don’t get me wrong. Emotional thinking can be valuable in the right situations, such as when a ball is flying very quickly at your head. Based on your past experiences with flying balls and some rules of thumb you’ve learned about the result of said balls hitting your head, you take action by ducking or otherwise avoiding the ball.
So you definitely need that kind of thinking and you use it quite often every single day.
The real issue is that while emotional thinking works well in familiar situations that are easy to understand and quantify, it does poorly in unfamiliar situations or those that are complex and difficult to understand.
And so we need to invoke the deliberative mode of thinking when we find ourselves in these types of situations. This type of thinking is what we most often refer to as logical thinking – when we deliberately force ourselves to think through various steps in order to form a conclusion. It takes more effort and is much slower than emotional thinking but it allows us to rationally analyze a situation in ways our emotions just can’t do.
However, as it turns out, there is a fairly big problem in that our brain is severely limited in how much information it can process when we’re deliberately thinking things through. So it invokes our emotional thinking quite often – without us realizing what’s really happening.
Although we might think we’re analyzing a situation with Vulcan-like logic, what’s usually happening is we’re using logic on the high-level bits but handing off the lower-level pieces to be processed by the intuitive part of our brain – because the logical part of our brain can’t handle the amount of information and the effort it requires to analyze that much information.
Now we might be able to process smaller tasks completely with logical thinking, but for most tasks it’s a combination of the two. Unless, of course, we’re just using the emotional part – which, as I mentioned, we do quite often.
Therefore our thinking can be strictly logical (for relatively small tasks), strictly intuitive (for many tasks we do during a typical day) or a combination of both.
When we use a combination, we can end up with a situation where both agree on the solution or they disagree (such as when you’ve logically come to a conclusion but have a, “gut feeling,” it isn’t the right one).
Psychologists have been studying the results of these two different types of thought processes for decades and have published numerous papers on the problems they cause in general and, more specifically, how this type of thinking can be very dangerous when investing.
A learning experience is one of those things that says, ‘You know that thing you just did? Don’t do that.’ “
Douglas Adams
I believe this is a major issue that must be addressed by every investor before he or she starts investing and, as such, I’ve devoted an entire chapter to it in my book, “The Pragmatic Investor,” so I won’t delve into it further here.
As Douglas Adams is fond of saying, “A learning experience is one of those things that says, ‘You know that thing you just did? Don’t do that.’”
Fortunately, at least when it comes to investing in the stock market, there is a simple solution: remove your emotions completely from the investing equation.
But, if what I’ve said is true and for complex tasks (of which investing qualifies) we unconsciously use our emotions despite our best intentions, then how can we completely remove our emotions?
Using Proven Systems
The answer lies in using a proven system. It’s similar to why pilots use checklists before each and every flight (even the experienced ones with decades of flying experience) and it’s why large companies, such as McDonald’s, remove individual choices from employees and simply require them to follow a set of pre-thought-out rules.
It is possible to break down a complex task into smaller chunks and process them using our logical minds. The problem is we can’t do it all at once and, even when we’re done, we usually can’t remember all the steps in order to repeat them again.
Lots of steps, lots of information and lots of choices paralyze us and render us unable to come to a rational conclusion.
So we need to create a system of logical steps we can follow that will override our emotions and we need to implement this system in a way we can effortlessly repeat it. But, as it turns out, that’s easier said than done. Even when our logical mind absolutely, positively, without-a-doubt, knows we have worked out a good plan, our emotional mind still triumphs in many cases.
It’s like the old story of a man riding an elephant. He thinks he’s in control and can get the elephant to go where he wants it to go – until the elephant decides it’s not going to go that way. Then the man realizes he’s not really in control of anything.
Similarly we can think we have our emotions under logical control — until our emotions decide to do what they want to do. Then all bets are off.
Fortunately all is not lost and I’ll describe a few good ways to keep your emotions in check when investing your money in the stock market. Keep in mind however, nothing to do with the stock market and your emotions is foolproof. To quote Douglas Adams, again, “a common mistake that people make when trying to design something completely foolproof is to underestimate the ingenuity of complete fools.”
In other words, no matter how well thought out a system you implement, you must always be on your guard lest emotions or illogical situations arise without you realizing it.
A common mistake that people make when trying to design something completely foolproof is to underestimate the ingenuity of complete fools.”
Douglas Adams
As I mentioned, most of our behavior is governed by our intuitive mode of thinking. We go through our daily routines guided by habit and gut instincts. From driving to walking to crossing streets, we rely heavily on our instincts and don’t consciously think about what we’re doing.
We only engage our deliberative mind when we’re faced with new or unexpected situations or when we intentionally focus on a specific task.
However, despite these facts, we generally believe our deliberative mind is always in charge (or mostly in charge at any rate) hence when asked whether they are rational and make logical decisions, most people will respond in the affirmative. Very few people actually think they are irrational and consistently make bad decisions.
Unfortunately, like the man riding the elephant, people rarely think things all the way through when investing in the stock market. The control they believe they have is an illusion.
Still, even when we’re riding along using our intuitive mind, we’re usually thinking with our logical mind to some degree. While driving home from the grocery store (and not actually thinking through the steps necessary for driving), we are probably thinking about what we need to do when we get home.
The man on the elephant is thinking about what he’ll do when he arrives at his destination while the elephant is doing the work of taking the rider to that destination. As long as the elephant is doing its job, the rider is free to think.
But if the elephant decides to veer off track, all the rider’s thoughts won’t help him.
In order for things to work out, both the rider and elephant need to work together in much the same way our logical and intuitive minds need to work together.
However most people don’t realize the extent to which their prior experiences and reactions guide their current behaviors.
Pattern Recognition
As time progresses we are constantly learning. Our experiences teach us whether something is worthwhile or not – in other words, we are creatures of pattern recognition and once we recognize a pattern, we instinctively jump to the response we’ve associated with this pattern in the past.
Our emotional minds are grounded in simple patterns and their associated responses, such as the pattern of red flashing lights in your rear view mirror and your instant reaction to pull over, or the flash of lightning and your expectation to hear thunder.
These types of patterns and responses are constantly bombarding us in everyday life. If they are important enough, or they repeat enough times, our brains store them and subsequently use them as a shortcut in the future without us having to think about it – this is why when learning something for the first time, such as driving a car, it takes intense effort and concentration. However as experience grows and our brains recognize and store the various patterns associated with driving, it takes less and less concentration, eventually reaching a point where we can drive the familiar route from office to home without recalling much of what we just did.
This is how our emotional mind learns and responds without our deliberative mind even being aware. And therein lies the rub.
Once the patterns have been stored, they take on a life of their own. We tend to recognize these stored patterns and use the associated responses for things that are completely out of context – such as the stock market. Our minds see certain situations and find previously stored patterns that are, “similar,” thereby invoking the associated response even when these situations are not actually similar and using the stored response isn’t justified.
You live and learn. At any rate, you live.”
Douglas Adams
This occurs when we give into greed and fear. We see a pattern for, say, a hot stock that is similar to something that benefited us greatly in the past and we transfer our greed response to that stock. In reality the patterns aren’t the same. The hot stock will most likely not benefit us at all but rather will probably make us lose money, yet our intuitive mind thinks the patterns are the same and automatically invokes the incorrect response.
When we give into fear, something similar occurs. In essence we don’t learn from our experiences because we don’t distinguish granularly enough between the slight differences in trigger patterns.
Douglas Adams put it nicely when he said, “You live and learn. At any rate, you live.”
These patterns and responses are more commonly called habits – which is simply a repeated behavior automatically triggered by cues from our environment. And in many instances, we’re not consciously aware of what’s going on.
Habits save us from the tiring intellectual work required by deliberative thinking – we basically outsource control of things we’ve seen before and know how to handle to our intuitive mind while keeping our logical mind free for the more important tasks.
Forming Habits
In general we see habits formed in two ways. First, repetition is usually enough to build a habit. If you do something enough times based on some trigger event, your brain will form a strong association between that event and your response to it. Then when the trigger occurs in the future, your intuitive brain simply reacts without you having to consciously think about it. We see this in action when people watch sports on television. When an intermission occurs, or even a break in the action (the trigger events), millions of people jump up off the couch and run to the kitchen or bathroom (the response). Most do it without thinking about it. They’ve done it so often in the past it’s now become an automatic habit.
Secondly, habits can be formed based on rewards. If we are rewarded with something we like, our brain tends to strengthen the association with the trigger event and response. Rewards give us the impetus to respond to the trigger in anticipation of the reward, and this bond can form without much repetition.
This is why people continue to eat unhealthy food although they know it’s bad for them. They see an advertisement or drive by a fast food restaurant and that triggers their response – which is to order the unhealthy food to receive the reward (which is to fulfill a craving or bask in the buttery taste).
What’s worse is once the habit has formed, the reward is no longer necessary for the response to be automatically invoked when the trigger event occurs. That’s the reason people will eat bag after bag of potato chips even when they are no longer enjoying them.
And this is what causes gamblers to play the game. They dream of the reward and intuitively jump into the game regardless of the fact they know the odds are dramatically stacked against them. Chronic gamblers have strengthened the bond between trigger event and response to such a degree they have no control over their response. Their intuitive minds overwhelm their logical minds in much the same way a rider cannot do anything to control a rampaging elephant.
In the stock market we sometimes see the same dynamics at play. It’s the reason so many people buy bad or overpriced stocks without doing a modicum of research. They’ve conditioned their minds to believe a popular, hot stock will make them lots of money and so they jump into the markets head first. And they continue to do this regardless of the fact they usually don’t do well.
In essence they have wired their brains to act on the event (by responding appropriately) in anticipation of the reward even if the reward never occurs. Just the possibility of the reward is enough to cause many people to throw out logic and follow their emotions.
The trick is to understand what is going on in your brain before you start investing. You need to ensure you’re not riding an out of control elephant when your money is on the line. It’s a difficult thing for most people to do because they succumb to greed and fear far more easily than they do to logic.
But it is possible. Find an investing system you trust. Use your logical mind to evaluate the system and don’t rush it. Perform your own due diligence and convince yourself the system works across different market conditions.
Once you’ve found the right system for you, force yourself to follow it. Understand your intuitive mind (ruled by emotions) is going to put up a fierce battle but it’s in your best interests to ignore your emotions and stick with the system.
Tame Your Mind
It’s much easier to do it this way because you don’t have to wage a full scale war against your intuitive mind. Simply use your logical mind to enforce the system (it’s much less work than having to overcome your intuitive mind and then have to come up with a plan of action – your action plan is simply to follow the pre-determine steps laid out by your system).
Doing this gives you the best chance of outperforming everyone else in the stock market. It gives you an unfair advantage because most people are unaware of how their mind controls their behavior and continue to act illogically even when it’s clear their actions are hurting their portfolios.
All you really need to know for the moment is the universe is a lot more complicated than you might think, even if you start from a position of thinking it’s pretty damn complicated in the first place.”
Douglas Adams
And if you’re looking for a proven system, look no further than Value Investing. Despite the hype you’ll see about short-term trading methods, get rich quick schemes and other such stock market nonsense, buying great dividend paying companies with strong economic moats at a discount and holding them for a long time is still the best way to make money in the stock market.
You’ll only delay your wealth potential by following shoddy plans and strategies.
As Douglas Adams said, “all opinions are not equal. Some are a very great deal more robust, sophisticated and well supported in logic and argument than others.”
And to wrap up, if you replace the word, “universe” in Adams’ quote below with the words, “stock market,” it pretty much explains why you need a system and can’t simply rely on your own mind.
“All you really need to know for the moment is the universe is a lot more complicated than you might think, even if you start from a position of thinking it’s pretty damn complicated in the first place.”
