Personal Wealth Management / Behavioral Finance

Sheer Reduction

Using neuroscience to analyze markets is all the rage. That could be bad news for investors…

Rejoice! Psychology has stepped from the murky shadows of wishy-washy humanities into the shining daylight of scientific inquiry. Intellectuals far and wide are using neuroscience to explain all we do, from choosing a mate to choosing food to choosing a stock.

What's more, brains have hit the mainstream. The literary tableau is speckled with books on brains: how they evolved and why they make us do what we do.

But there's a dark side to this revolution. As with any cutting-edge field of study, new ideas get thrown around wildly, and most conclusions are at best preliminary, but often just wrong. Scientific theories take years or decades to vet—requiring testing and retesting before they're canon.

The mainstream media moves too fast for all that. Once the intellectual paparazzi gets a hold of a new theory, things tend to spiral out of control and ideas are often distorted, misconstrued, and scads of irrational conclusions are consecrated as scientific truths. And the investing community is not immune.

Let me show you what I mean. Below is a quote from a new book entitled Mobs, Messiahs, and Markets by William Bonner and Lila Rajiva. The book uses behavioral economics to analyze market behavior.

"What if all [animals and humans included] simply act according to various prefigured survival strategies, the purpose of which—as far as we know—is nothing more than genetic replication?"

Essentially, this is a riff on Richard Dawkins' theory of the Selfish Gene. Hearkening back to the mid ‘70s, the idea posits that organisms act principally to replicate their own genes and enable survival of the species.

Now, it's worth noting Bonner and Rajiva's book is full of useful and thought-provoking ideas. But there's a big problem lurking in their prose: their representation of the Selfish Gene is vastly over-simplified and too rigid to reflect reality. The academic term is reductionism, and it's rampant in today's pseudo-intellectual culture.

Reductionism is more dangerous than it might initially appear. By operating on the premise gene replication is the only explicable rationale for animal behavior, science is sent backward, not forward. Representing humans as pure automatons of genome willpower is essentially a re-visioning of BF Skinner's theories on instinct and Pavlov's dogs. It isn't cutting-edge neuroscience; it's a cognitive U-turn back to the 20th century!

Many new books and articles on economics and human behavior take a reductionist approach, and it's something to be wary of. Reductionism can thwart your investment analysis as fast as any basic miscalculation.

Just 10 years ago scientists believed once the human genome was mapped, we'd hold the key to countless medical breakthroughs, which would occur in rapid succession and revolutionize all medicine.

Well, we mapped the genome only to find it wasn't that simple. No, the real keys to understanding human life had to do with the proteins those amino acid strings produced—in what measure, at what time, and in what combinations. And then we found it's not just protein synthesis, but protein interaction with the surrounding environment that's probably responsible for expression of traits. Put another way, understanding the keys to human life is vastly more complicated and nuanced than just mapping amino acid chains.

And so it is with understanding brains. The more work done in neuroscience, the more complicated things become. Every neuron is interconnected and dependent upon other neurons—interconnections so vast and intricate that simply understanding how the brain "sees" an image captured by the eye is enormously difficult.

Simply, understanding humans—from the molecular to the behavioral—is trending away from simple dictums toward greater complexity and intricacy. Just so, stock markets are too vast and complex to be reduced to rules everyone can follow. If it were so easy, we'd all be trillionaires.

This isn't to say all reductionist thinking is bad. Science is based upon reducing the world to equations and ideas we can understand and use. The true test of any theory is its predictive power. A theory can be wholly logical but still not work in practice. If a theory can't repeatedly forecast an outcome, it's of little value. Apply the simple test of reductionism to the grandiose claims of behavioral scientists and market gurus, and it'll be apparent how flimsy most theories really are.

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

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