Tuesday, December 06, 2005

Financial Bubbles, Damaged Brains and the Condition of Society Today

On 21 July this year (2005), there was an intriguing article published by Jane Spencer, a staff reporter, in The Wall Street Journal.

Titled "Lessons from the Brain Damaged Investor", it said that researchers from the Stanford Graduate School of Business, Carnegie Mellon University, and the University of Iowa had concluded that people with an impaired ability to experience emotions might be able to make better financial decisions than other people under certain circumstances.

Intrigued, I thought I would follow up at some convenient time. That has finally arrived, and I found that the research had been published the previous month in the peer-reviewed journal, Psychological Science, so we can be confident that the study is "scientifically valid", at least from the viewpoint of the peculiar mixture of science and art that is called psychology. Actually, the research is part of a fast-growing interdisciplinary field called "neuroeconomics" that explores among other things the role biology plays in economic decision making, by combining insights from cognitive neuroscience, psychology and economics.

The fifteen brain-damaged participants who were the focus of the study had normal IQs, and the areas of their brains responsible for logic and cognitive reasoning were intact. But they had lesions in the region of the brain that controls emotions, which inhibited their ability to experience basic feelings such as fear or anxiety. The lesions were due to a range of causes, including stroke and disease, but they impaired the participants' emotional functioning in a similar manner.

In the study, the participants' lack of emotional responsiveness gave them an advantage when they played a simple investment game. The emotionally impaired players were more willing to take gambles that had high payoffs because they lacked fear. Players with undamaged brain wiring, however, were more cautious and reactive during the game, and wound up with less money at the end.

The trouble with biologists and psychologists is that they do not understand real-world finance. The way their game was constructed "rewarded" taking high risks. In the real world, high risk can sometimes equal high reward, but it can also mean high loss, or complete loss, of capital.

The highest-risk form of investment is straightforward gambling, and the returns from that are well established. If you are in love with gambling, then the best way to "play" is not to place bets, it is to set up a company that organises gambling games or, better, invest in a company that is already successful at gambling. (NOTE: I am not recommending that you be involved in gambling at all. I personally consider gambling immoral – not necessarily to participate as a gambler (that is merely financially stupid but if you enjoy the activity I can't see that a moderate amount of the activity does any harm – the problem is only that one can get "hooked" on gambling, but then one can also get "hooked" on chocolate or coffee or anything else, so it is not the coffee or the gambling that is the problem here, but one's tendency to get "hooked"); however, organising gambling as a commercial activity is immoral because it exploits the weakness of those who are most vulnerable to the "attractions" of gambling, such as emotionally and financially weak people.)

Having considered the study, I can only conclude that the researchers "fixed" the results by "fixing" the rules of their game. If you construct a game in which those who take high-risks win (which is not necessarily the case in the real world) then you will get high-risk takers winning.

The only thing that the study proves is that brain-damaged people are less able to take a balanced view of the nuances of a situation, and so are more likely to take higher (and probably unrealistic) risks.

So all that the study proves is that brain-damaged people are likely to take high risks – but we did not need the experiment to tell us that!

Modern academic activity is unfortunately now too full of such rubbish. My advice to anyone thinking of investing their lives in such research is to stay away till the researchers can learn some basic lessons about logic, experimental design and real-life economics, finance and investing.

In fact, we have known from experience for at least a hundred years that successful investing requires objectivity. To put it differently, it requires the ability to look at all the facts and come to one's own rational conclusions. It requires the ability not to be swayed by emotions such as fear or greed or ambition or what might be called the "herd factor".

On the other hand, the successful investor does have to take the "herd mentality" into account rationally as a factor in making any investment decision today, because so much of the market has stopped being driven by fundamentals. Most of the market is in fact driven by emotions as more and more "small investors" are doing their own investment and disinvestment. As these inexperienced and professionally untrained and perhaps even psychologically-unsuitable investors have entered the market in greater and greater numbers, they have changed the nature of the market from a more or less rational field, to an increasingly emotion-driven field.

The challenge as an investor is how to "sense" where the market is going, when there are no (or few) fundamentals to guide you. The current housing bubble in metropolitan areas around the world clearly illustrates the challenge. We know that, from the viewpoint of fundamentals, house prices should have started coming down a long while ago. The key questions are: WHEN will they actually start coming down and how far will they fall.

A parallel case was the IT bubble from 1998 or so till Spring 2000. No one knew when the "bust" would begin or how low prices would fall, even though it was clear (certainly from 1998) that the situation was a real bubble. But we had apparently serious students of economics, technology and finance telling us that we were in a "new economy" where the old rules did not apply. The old rules certainly did not apply in this market for a couple of years or more, but then they struck with a vengeance.

So investors who were stupid, emotionally-challenged or even brain-damaged could profit for a couple of years from a market gone mad. And they did profit. Many executives ended up in top positions simply because they were functioning in an area which "benefited" from that madness. Many CEOs earned millions who should never have been CEOs in the first place. Many companies were bought and sold that should never have been bought or sold (think AOL-TimeWarner). The ability to be genuinely objective is unfortunately too rare, whether among investors, executives or CEOs. It is easy to be influenced by what is currently fashionable or by your class or your nation or your own family.

However, the good thing is that everyone can play and you might be lucky or unlucky with your timing. The "irrational exuberance" regarding shares the late 1990s has, since then, been replaced by the "irrational exuberance" regarding housing now. Only a fool will invest in housing now. But fools can get lucky. (I am just buying a house myself at present, but that is for domestic reasons and because I have no option in the location where I need a house).

The interesting question, as more and more people enter the investment market and realise that ones needs to be either lucky or "brain damaged" in order to be successful is the following: "What are the consequences of living in a brain-damaged society such as we are producing today?" Sphere: Related Content

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