Behavioral Finance

Cheerless Recoveries

Expect investor sentiment and broad economic data to stay dour even as stocks recover.

How We Decide, by Jonah Lehrer

The Art of Choosing, by Sheena Iyengar

When you get right down to it, most newfangled studies of behavior are getting at a single thing: choice. How do we choose, and why? If you can figure that out, understanding why we make mistakes and similar questions are easier.

Of course, understanding choice is the $64,000 question of the neuroscientific era (but it's nothing new—philosophers have grappled with it forever too). We don't even all agree that we get to choose at all! To this day, some psychologists contend choice is instinctual, unconscious, out of our control.

In my own investing travails, I've less asked the question, "How are we irrational?" and instead asked, "How do we choose?" Of course we're all irrational at times, but why? It's a question for the individual as well as the crowd. As often argued in this space, the crux of the issue, ultimately, is self knowledge. Psychology (the kind that doesn't include pill-popping) is at core about exploration and understanding yourself, and that's the thing leading to greater control and awareness. We too often shun this basic fact because a dominant feature of irrationality is the illusion of control—we believe our reason, our consciousness, can rule the roost. It can't. Our minds are much larger than just our awareness. From where does love or hate come? Surely not reason. Yet those are as important as any datum and foundational to choice, whether we like it or not.

Enter Jonah Lehrer's fantastic, and pithy, How We Decide. Like his debut, Proust Was a Neuroscientist, this book is a tour de force of lucid, simple explanations about how our brains work, yet is bursting with ideas and insight. Lehrer is one of the only popular authors to consistently offer deep thinking on contemporary neuroscience, not just reductive conclusions. Anyone interested in the psychology of investing, or popular psychology in general, should read this book.

Lehrer, unlike behavioral economists, doesn't care about explicit irrationality. That is, he doesn't have an agenda to disprove classical economics. This frees him to tackle issues of behavior in ways economists mostly don't. He tells us the subconscious brain also "thinks," and emotions are in fact a kind of thinking—they are "messages" from the unconscious parts of our brain delivered to our awareness. More, that the neocortex (where reason happens) is one of the weakest and smallest parts of the brain! In fact, the unconscious works faster, and is often more right, than reason (à la Malcom Gladwell's study of intuition, Blink). To access the vast power of the full brain, there must be room made for the emotional unconscious—to actually listen to, but not necessarily follow, those messages.

In a shrewd move, Lehrer describes the brain's neocortex (where our "reason" resides) as being the regulator of our brains—to provide a circuit breaker for emotional impulses that might be wrong. It's less likely our neocortexes were designed for actual forward-thinking reason, though that's what we generally use them for. This idea of regulation rather than reason is a hugely important perspective for investors. True masters, with reason and experience on their side, understand how to allow all parts of their brains to have their say. Different parts of the brain will disagree with each other; the brain sends mixed signals and is rarely harmonious. Simple awareness of this ought to allow us to override what "feels" right but we know isn't.

For investors, intuition sometimes serves us well, but more often leads us astray. Why? For one thing, intuition tends to fail because the stock market is a really tricky feedback mechanism—it prices in what people learn and anticipate, so it's tough for a brain's lower functions to really home in on anything consistently right. Nevertheless, Lehrer reminds us that over-thinking can lead to as many wrong decisions as relying on the gut alone. But at times, he can be too reductive—it's not right to say Garry Kasparov makes all his chess judgments based on past experiences. Though it's certainly true that great chess players use their intuitions, their faster-computing unconscious minds, to quickly pare available moves down to a set of the best choices.

Lehrer finds that the brain can't handle the complexity and non-intuitive parts of the market, and therefore no one should ever try to beat it. He would've done better to examine the psychology of those who have in fact consistently beat markets as opposed to speaking to the lowest common denominator. Still, he offers a handful of worthy insights: Fear of losses (loss aversion), for instance, makes people more willing to accept a measly rate of return directly after they feel losses (like a big bear market). This is why investors often miss the first parts of stock bull markets even though that's a spot where the biggest gains can be.

Meanwhile, Sheena Iyengar's Art of Choosing is a broader meditation on the issue of choice in everyday life. Iyengar is adept at weaving current psychological findings into little stories and anecdotes, but often veers too far from topic. Too much time is spent on cultural relativism, issues of equality, and so on, that can be tangential to choice but aren't explicitly about it. Still, in relief to Lehrer, the book is quite a good complement, offering reinforcement and treading territory Lehrer doesn't. Perhaps Iyengar's best contribution is the idea that interpretation of information is as important to choice as anything. Simple perspective can make two people interpret the same event differently. Investors should always keep this in mind, and it is specifically why MarketMinder's front page links to perspectives from a variety of sources each day—both those we agree with and ones we don't. You can't make a good choice if you interpret the situation wrong to begin with.

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