Behavioral Finance

Brain Discord

By, 12/09/2006

We have to live with ambiguity and discord every day. It's all over the place. Theories often contradict each other; and limited information, faulty logic, and emotions can cause us to believe things that aren't true or skew our memories. Heck, a lot of initial reactions and emotions we experience are contradictory to how we'd prefer to have acted in the first place.

A fundamental tenet of Evolutionary Psychology and Behavioral Finance is that the "software" of the mind is adapted for specific functions just like any organ of the body. For instance, the heart was made specifically to pump blood, the stomach made specifically to store and digest food, etc. The same is true for the brain. Our instincts are like little "mental organs", all there in the grey matter. Each instinct was designed by evolution to solve a specific problem. The brain is an awe-inspiring machine. Only one problem: it was designed for a different world.

Meaningful changes in evolution require time. Genes need time to change (like tens or hundreds of thousands of years) to combine and recombine through many generations of replication in order for something pervasive and new to emerge. Think about the complexity of the eye: it would take a long time for nature to design a system that complex! Our brains are more complex than the eye by many magnitudes.

Evolution is about solving problems. How do I survive? How do I eat? How to I mate? So that means things evolve according to the problems posed by the external environment. Here's the thing: 99.9999999% of the history of life on Earth doesn't feature civilization as we know it. That means 99.9999999% of time evolution's had to create organisms was in the wild. Which means just about all our adaptations and modifications were made for something different than what we've got today.

Civilization moves faster than evolution. So even though our surroundings change quickly, our genes aren't changing nearly so fast. That's why Behavioral Finance can be very powerful. Capital markets are developing—evolving—at an accelerating pace. But humans, and the ways they act and react, are far more stable.

Behavioral finance, then, becomes one of the only truly gameable parts of investing. Human behavior is pretty consistent over history. The last 100 years, for instance, is nowhere near enough time to change the brain's basic software through evolution. Yet, the sweeping changes to the world in that time make a lot things just a couple decades old completely non-comparable today.

We've talked a lot in the past about "accumulating pride" and "shunning regret". These are Stone Age habits of modern investors—parts of mental software originally designed to help people survive and achieve success in getting food and fending off attackers.

Here's another one: Cognitive Dissonance. It's what happens when an individual encounters a reality that's counter to their inherent belief. (This is really very similar to confirmation bias, pride accumulation, and regret shunning.) Cognitive dissonance creates anxiety in a person. Anxiety and fear and other sorts of tension are evolutionary imperatives for action: we want to resolve that tension so we're not tense anymore!

Leon Festinger, the theory's founder, said "this incongruity is as uncomfortable to the human organism as hunger." One way or another, the anxiety must be assuaged. When there is no rational, or truthful, way to resolve the tension—we make up stories. "Because of cognitive dissonance, facts can be as malleable as clay."

It's easy to see how this can affect investors. Economics and financial theory themselves are rife with incongruities and wildly different explanations for what's happening in the world. We've read no less than 10 different "expert" explanations on why the dollar has fallen this year. The falling dollar creates anxiety in people, and people need a good story to ease that tension.

The best thing is to persevere through the tensions of life's incongruities and seek the truth. The only way we know to accomplish that in investing is with the Only Three Questions That Count (www.onlythreequestions.com).

Cythia Crossen's article on Cognitive Dissonance in last week's Wall Street Journal gives numerous examples and a little background:

'Cognitive Dissonance' Became a Milestone In 1950s Psychology
Cynthia Crossen
http://online.wsj.com/article/deja_vu.html

And if you want to delve even further into the theory and its roots…

http://en.wikipedia.org/wiki/Cognitive_dissonance

*The content contained in this article represents only the opinions and viewpoints of the Fisher Investments editorial staff.

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*The content contained in this article represents only the opinions and viewpoints of the Fisher Investments editorial staff.