as eachtries to outdo the others. A nonbillionaire sailor may feel happy simply tobe in the same marina as such beautiful boats.
Portfolio managers can also suffer from the comparison effect. Whenmanagers miss out on a market rally, then they can become disappointedthat they are not achieving their expected performance and anxious aboutunderperforming their benchmark (and their colleagues).
Sometimes the best-performing money managers are lauded withpraise. Yet too often this praise is followed by underperformance. Why?Perhaps they lose the motivation that was driving them in the ﬁrst placewhen they achieve their goals. When one measures success by compar-ing oneself to another (like the hare in Aesop’s fable of the tortoise andthe hare), then winning the comparison makes one feel happy, but alsodeprives one of the motivation to continue working hard. If one is outper-forming expectations, then why continue to work so hard? Success canthus be a performance trap if it is measured by comparison to others orother external benchmarks.
Alternatively, when success is measured according to an internalbenchmark, such as an improved decision process or clearer judgment,then it remains an enduring motivation and leads to long-term excellence.Portfolio managers who focus on reﬁning their decision process, stokingtheir curiosity, and developing a sound investment philosophy are morelikely to be long-term outperformers. Chapter 22 discusses this issue inmore detail.
Via the comparator, emotions arise when feedback about one’s expec-tations is received. The level of attachment to one’s expectations (ego in-volvement) determines the strength of his or her emotional responses togoal-related feedback. This explains the popularity of Zen- and Buddhist-themed books for traders and investors. Teaching detachment from theoutcome, not the process, is the goal of these books.
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Outcome comparisons arouse emotions. Detaching oneself from out-comes reduces one’s emotional arousal and emotion-driven judgment bi-ases. People who practice Buddhist meditation may more easily perceivethe quiet murmurs of intuition while calming the loud voices of excessiveemotion. Unfortunately, because most investors are attached to the out-comes of their trading (e.g., because their bonuses depend on those out-comes), they are vulnerable to the inﬂuence of reactive emotions.
BELIEFS AND EXPECTATIONS:THE PLACEBO EFFECT
Sometimes expectations of successful goal progress create a self-fulﬁllingprophecy. A belief in one’s ability to achieve a goal activates inner re-sources to support goal pursuit. Such success beliefs prompt supportiveneurochemical shifts, which enhance mental and physical endurance.The placebo effect is an important example of how one’s beliefs, desires,and expectations can align to change his or her state of being. When aphysician gives a patient a medicine, it represents a belief that the patientwill get better, which reinforces the patient’s internal motivation to regainhealth.
Irving Kirsch, a psychologist at the University of Connecticut, analyzed19 clinical trials of antidepressants and concluded that the expectation ofimprovement, not adjustments in brain chemistry, accounted for75 percent of the drugs’ effectiveness.5 “The critical factor,” says Kirsch,“is our beliefs about what’s going to happen to us. You don’t have to rely ondrugs to see profound transformation.” Between 35 and 75 percent ofpatients beneﬁt from taking an inactive sugar pill in studies of new drugs.For centuries, Western medicine consisted of almost nothing but theplacebo effect.6
While the placebo effect can improve health based on a belief in a pos-itive outcome, a nocebo effect is an ill effect caused by the suggestion orbelief that something is harmful. In both the placebo and nocebo effects,the expectation of an outcome creates a self-fulﬁlling prophecy.
In the markets, participants’ expectations are rapidly priced in. Muchof the art of investing is the ability to understand one’s own expectations,the market’s expectations, and the economic fundamentals. When the mar-ket’s expectations deviate from underlying fundamentals, an expectation-related emotional shock is more likely going forward. For example, whenInternet stocks with high price-to-earnings (P/E) ratios climbed far beyondreasonable expectations for growth, pricing in the market’s overoptimisticexpectations, it became clear that the differential between expectations
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and reality would eventually be narrowed as these stocks failed to keep upwith investors’ lofty goals.
A stock’s P/E ratio generally reﬂects investors’ growth expectations.Ironically, stocks with low ratios (and low expectations of growth) oftenoutperform those with high ratios over time. This is one tenet of value in-vesting (see Chapter 23). One reason why value strategies work well is thatinvestors’ low expectations are more frequently positively surprised, lead-ing to increased positive emotion being associated with the low P/E stock,while high P/E stocks more often disappoint because the “good news” isalready priced-in.
MAKING SENSE OF THE NEWS
Every day after the markets close, journalists interview traders looking forthe reasons behind the day’s market action. The proffered explanationsare typically concrete and logical. Market moods are often explained in acause-and-effect relationship with recent events. For example, followingthe October 19, 1987, crash in world stock markets, the BBC attributed themarket plunge to rational news-driven panic: “Trading activity was drivendown by growing fears of rising interest rates and a falling dollar. Thesewere exacerbated by the news that the US had retaliated against Iranianattacks in the Gulf by bombarding an offshore oil rig.”7
The BBC’s logic is faulty because it attributes the panic entirely torecent price action and world events. News and price changes do inﬂu-ence investors’ emotions, and there is a positive feedback effect from suchevents on how investors feel. Yet the depth of the panic did not reﬂect theintensity of the mildly negative news. Investors were already predisposedto panic on that October day.
In a post-note to the BBC article, the editors admit that, “The debateover the cause of the crash continued for many years after the event buteconomists have never been able to name a single factor that ushered inBlack Monday.”8 In hindsight, the news-driven explanation for the crashwas dismissed, and uncertainty was given its due.
Why does the BBC seek a single-factor explanation for the panic?Maybe because its readers are uncomfortable with uncertainty and the lackof control it implies. If you hear that investors panicked, you immediatelywant to know why they panicked. “Because they were afraid” isn’t a sat-isfying explanation. “Because they were overconﬁdent” is also inadequate.“Because interest rates rose” ﬁts into a neat mental model.
One deﬁciency of causal reasoning in market commentary lies in thedirect attribution of investor emotion (such as fear and greed) to recent
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news events. Yet sometimes bad news doesn’t provoke fear or move themarket, while other times it does. Why does some news cause fear at onetime, but similar news provokes no reaction a few months later? How in-vestors interpret news and events depends on their underlying emotionaloutlook. Optimistic investors see a sharp price plunge as an opportunity to“bargain shop” for cheap shares, while pessimists view it as evidence thatthe global ﬁnancial system is collapsing.
Interestingly, there are periods of time when strongly negative newsdoesn’t impact an optimistic market, and times when positive news cannotrevive a bear market. During these periods, investors are succumbing, on agroup level, to emotional defense mechanisms. Emotional defense mecha-nisms are a form of self-deception that distort investors’ interpretations ofnews that contradicts their strongly held beliefs.
SELF-DECEPTION
While the media “rationalize” market events in hindsight, individual in-vestors have their own emotional defenses and contortions of logic to con-tend with. Especially when under stress or when confronted with negativepersonal information, the brain has a tendency to cope by means of self-deception.
Emotional defense mechanisms are the process by which the mindminimizes the negative emotions that arise from an unfavorable com-parison. Negative emotion can be attenuated through distorted logic(rationalization), avoidance (denial), believing an internal feeling is alsobeing felt by another (projection), or blaming circumstances out of one’scontrol (externalization). In an example of projection, when investorsfeel uncertain about the market’s future direction, they often believe theirown disorientation is a result of “market uncertainty.” More often thannot, the source of the uncertainty is in the investors themselves. Oneexample of externalization is retail traders blaming their market losseson “manipulators” rather than taking responsibility for them. Defensemechanisms operate unconsciously, yet they have a profound effect onthe ability to perceive reality and develop accurate expectations.
A few biases discussed in this book result from emotional defensemechanisms. The hindsight bias, rooted in memory, involves excessivelyoptimistic assessments of one’s past accomplishments, often fueling fur-ther misguided endeavors. The conﬁrmation bias drives an active searchfor facts that support one’s opinions and beliefs, while contradictoryinformation is ignored. The projection bias involves misjudgments aboutone’s future needs and desires, arising from one’s belief that one’s currentemotional state is similar to what one will feel in the future.
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EMOTIONAL DEFENSE MECHANISMSAND MOTIVATED REASONING
One defense mechanism, which is a type of rationalization, is calledmotivated reasoning. Motivated reasoning is thinking biased to producepreferred conclusions and support strongly held opinions.9 Like otherdefense mechanisms, motivated reasoning can be viewed as a form ofemotion regulation, in which the brain moves one toward minimizingnegative and maximizing positive emotional states. Motivated reasoningas a strategy for emotion regulation was ﬁrst described by the Vienneseneurologist and father of psychoanalytic psychiatry, Sigmund Freud, whoobserved that people can adjust their thought processes to avoid negativefeelings such as anxiety and guilt.
Professor Ditto at the University of California at Irvine set up an ex-periment to investigate motivated reasoning. He videotaped participantsas they self-administered a bogus medical test. The subjects were coachedthat one result color on the test strip was favorable, while the other was anunfavorable (but unnoticeable) diagnosis. Subjects who received the un-favorable diagnosis required more time to accept the validity of the testresult, were more likely to spontaneously recheck it, and believed that thetest had lower accuracy than those with the favorable results.10 Not onlydo people underestimate the likelihood of negative feedback about them-selves, but even after they are presented with it, they tend not to believe it(and actively argue against it)!
Researchers at Emory University studied motivated reasoning in po-litically active individuals before the 2004 U.S. presidential election. Theypresented contradictory statements from each candidate, George W. Bushand John Kerry, to subjects while they were observed in an fMRI scanner.After a short delay, the contradictory statements were then excused by anexculpatory statement provided by the experimenters.
Initially, when subjects were presented with their favored candidate’scontradictory statements, they demonstrated greater nucleus accumbensactivation (an area associated with positive emotion and motivation in thereward system). The authors speculate that this activation occurred be-cause “when confronted with information about their candidate that wouldlogically lead them to an emotionally aversive conclusion, partisans arrivedat an alternative [positive] conclusion.” The nucleus accumbens activationrepresented the emotion of relief as the threatening information was recon-ciled with their positive opinion of the candidate. The subjects were expe-riencing a positive emotional reaction to the resolution of tension. Accord-ing to the authors, the nucleus accumbens activation may represent thesubjects’ motivation to ﬁnd excuses for obvious contradictions.11 It’s plea-surable for them to resolve the contradiction, so they are motivated to do it.
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Interestingly, in the Emory study, “Motivated reasoning was not asso-ciated with increased neural activity in regions previously linked to ‘cold’reasoning.”12 When using motivated reasoning, partisans are rewarded(with nucleus accumbens activation) by resolving the contradictorystatements in their favor, and the brain regions associated with negativeemotion (the insula and lateral orbital-frontal cortex) are quieted.13 Theseresults suggest that emotional defense mechanisms may be a neuralprocess in which individuals are driven to ﬁnd information or adopt beliefsthat increase reward system activation (and reduce negative emotions).
People who engage in motivated reasoning perform more poorly ondecision-making tasks than those who are less defensive about negativeinformation. Researchers designed a card-sorting task where the fastestsolutions were achieved by considering threatening information. “Partici-pants who considered a Wason task rule that implied their own early death(Study 1) or the validity of a threatening stereotype (Study 2) vastly outper-formed participants who considered nonthreatening or agreeable rules.”In conclusion, “A skeptical mindset may help people avoid conﬁrmationbias . . . in everyday reasoning.”14 Actively confronting uncomfortable in-formation led to superior decision making.
Courage is essential when facing uncomfortable negative emo-tions. During a bear market it is easy to think about the economypessimistically—everyone is doing it. The goal in such a situation is tolook for the positive aspects of the economy—the ones that are beingoverlooked. This requires balanced thinking, courage, and a willingness tolook at all available information with equanimity. George Soros indicatedthat one of the keys to his acumen is the ability to nonjudgmentally thinkabout why his investment reasoning process may be wrong (his theory offallibility).
Understanding the effects of expectations, counterfactual comparisons,and emotional defenses on decision making is the ﬁrst step toward improv-ing performance. The next chapter will move back to a micro-level focuson the neurochemical origins of ﬁnancial decision making.
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C H A P T E R 4
NeurochemistryThis Is Your Brain on Drugs
“Depressives have Prozac, worrywarts have Val-ium, gym rats have steroids, and overachievershave Adderall.”
—Joshua Foer, Slate.com1
T he chemical components of foods, herbs, medicines, and illicit drugs
can profoundly alter ﬁnancial decision making. Some substances,such as alcohol, are well understood in their effects on ﬁnancialjudgment—so much so that casinos offer alcohol free of charge to weakengamblers’ self-control. However, the behavioral effects of some foods andherbs are little known outside obscure medical journals.
Many pathological mood states (such as depression, mania, anxiety,and obsession), neurological conditions (such as Parkinson’s disease andAlzheimer’s disease), and impulse-control disorders (such as kleptomania,compulsive shopping, and pathological gambling) are known to affect ﬁ-nancial decision making: depression is associated with risk aversion, maniawith investing overconﬁdence, anxiety with “analysis paralysis,” and com-pulsions with overtrading. Interestingly, the ﬁnancial symptoms of theseillnesses can be reduced by medications.
In this chapter, we examine how such chemicals change the percep-tion, processing, and judgment of risk-related information. For investors,the ﬁnancial effects of ingested chemicals is not an academic issue. Withtrillions of dollars exchanged daily on global markets, optimal judgment iscrucial. A minor improvement in decision-making accuracy can reap mil-lions of additional dollars in proﬁt.
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The chemicals discussed in this chapter alter neurotransmission. Neu-rotransmission refers to how signals travel between neurons. For mostpeople, healthy levels of neurotransmitters such as dopamine, serotonin,norepinephrine, and stress hormones can be maintained using a balanceddiet, a supportive social community, spontaneous play, regular exercise,and prayer or meditation. In some people, substance abuse, medications,overwhelming stress, or innate genetic propensities lead to chemical imbal-ances. It is for those states of imbalance that a ﬁne-tuning of brain chem-istry can have its most beneﬁcial effects.
INTRODUCING THE NEUROTRANSMITTERS
What is the use of learning about neurotransmitters in a book about invest-ing? Each individual is uniquely affected by ﬁnancial ups and downs. Theyhave different expectations and widely varying needs for stimulation, ex-citement, and security, and their differences are largely a product of theirunique biology, including their neurochemistry.
Neurotransmitters are the molecules that carry communication signalsbetween neurons in the brain. One’s personal neurotransmitter endowmentis based on (1) genetics and (2) past experiences. In this section, we’ll lookat correlations between neurotransmitters and those behaviors and emo-tions that are relevant to investors.
Some neurotransmitters are active in the cerebrospinal ﬂuid, whichbathes the brain’s cells. Small ﬂuctuations in their overall levels lead toprofound alterations in the frequency and intensity of neural signaling.
Other neurochemicals are secreted from the ends of neurons, transmit-ting signals directly to downstream neurons. They act on speciﬁc receptors(see Figure 4.1). They ﬁt into these receptors like a key ﬁtting into a lock.These transmitters stimulate a fast electrical or slow genetic response inthe second neuron (see Figure 4.2). Neurotransmitters are recycled fromthe synapse by the neurons that released them.
Very rarely is one neurotransmitter responsible for creating a particu-lar emotion or behavior. Instead, there is vast network of neurons releas-ing many neurotransmitters, most stimulating or inhibiting the activitiesof each other. Furthermore, many neurotransmitters act on multiple re-ceptor subtypes (there are currently at least 12 known serotonin2 and ﬁveknown dopamine receptor subtypes3), and there are currently 108 iden-tiﬁed neurotransmitters. Five of those neurotransmitters act throughoutmost of the brain: Histamine, serotonin, dopamine, gamma-aminobutyricacid (GABA), and acetylcholine. Of those ﬁve, we’ll be discussing serotonin
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FIGURE 4.1 The principles of neurotransmission. Neuron A sends signals toNeuron B via its axon.
FIGURE 4.2 A synapse. Neuron A releases neurotransmitters into the synapticcleft. When they ﬁt into receptors on Neuron B, they activate ion channels and geneticprocesses, which represent the intended signal.
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and dopamine in depth, and histamine, GABA, and acetylcholine in brief.Additionally, local actions of opioids, norepinephrine, stress hormones,and omega-3 fatty acids affect behavior and decision making. And if thatweren’t enough, common medications, street drugs, and foods also shouldbe considered for their neural effects on judgment.
Serotonin
Since the introduction of the antidepressant Prozac, serotonin has becomea household word. In 2005 in the United States, over 150 million prescrip-tions were ﬁlled for serotonin-increasing antidepressant medications.4Brain levels of serotonin are blamed for everyday maladies from pre-menstrual syndrome (PMS) to severe depression and suicide. Serotoninis a neurotransmitter, and when its concentration or receptor sensitivitychanges, judgment is altered.
In the 1970s, researchers discovered that people who committed vi-olent suicide appeared to have lower levels of brain serotonin than peo-ple who died by other means. Scientists then developed chemicals thatblocked the presynaptic neurons’ natural recycling of serotonin molecules.These serotonin reuptake inhibitor medications (SSRIs) delay the naturalclearance of serotonin after it has been released into the synapse. SSRImedications are used for the treatment of several emotional and behavioraldisorders. Fluoxetine (Prozac) is the prototype of these compounds.
Since the introduction of Prozac, several other SSRIs have been discov-ered and marketed by pharmaceutical companies, including brand-namedrugs Paxil, Zoloft, Celexa, and Lexapro. SSRI medicines were found to de-crease the severity of the symptoms of several disorders: Depression, anx-iety, obsessive-compulsive disorder, post-traumatic stress disorder, andpremenstrual dysphoric disorder, among others. Fortunately, the SSRIshave been a phenomenal success in reducing the symptoms of depressionand anxiety worldwide. Antidepressants are the third largest selling classof drugs in the United States—$11 billion dollars per year. As of 2003, an-tidepressant use had been increasing at the rate of 17 percent per year.Other classes of antidepressants exist, but I’ll focus only on SSRIs for sim-plicity’s sake.
There are weak, but signiﬁcant, genetic links between serotonin trans-porter genes and self-reported negative emotion. People who have twocopies of the short-form (S allele) of the 5-HTT (serotonin transportergene) are slightly more emotionally reactive and prone to depression thanpeople with two of the long form (L alleles) of the gene.5 Furthermore,individuals with two S alleles show greater amygdala activation (a proxyfor negative emotion) on negative emotion-inducing functional magneticresonance imaging (fMRI) tasks than those with two L alleles.6
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Experimentally, brain serotonin levels can be decreased by removingan essential amino acid, a precursor building block of serotonin, from thediet. The amino acid tryptophan (Trp) is converted into serotonin in neu-rons. In order to manufacture serotonin, people must consume Trp in theirdiets, as their bodies have no way of synthesizing it de novo. When Trp isrestricted from one’s diet, brain levels of serotonin should fall (as shouldlevels of melatonin—leading to an impaired sleep cycle). Trp is foundas a component of dietary protein, and is particularly plentiful in choco-late, oats, bananas, dried dates, milk, yogurt, cottage cheese, ﬁsh, turkey,chicken, sesame, chickpeas, and peanuts. Genetic research shows that mu-tations in serotonin and tryptophan genes each lead to decreased serotonineffectiveness and increased emotional sensitivity.7
Dopamine
Dopamine was originally thought to be the “pleasure” chemical of thebrain. A more accurate, modern view is that dopamine is involved in numer-ous cognitive and motor functions, including being the substrate of desire,motivation, attention, and learning. Illegal drug use is perhaps the mostcommon public association with dopamine. All known addictive drugs act,in part, through dopamine release in the brain. In fact, the word dope,used to describe illegal psychotropic drugs, was derived from the worddopamine.
In a famous experiment in 1954, researchers placed electrodes into the“pleasure center” of rats’ brains. When the rats were given the opportu-nity to press a lever to electrically stimulate this center (a dopamine waystation) they did so compulsively. In fact, many of the rats died from ex-haustion. The rats avoided food, water, and sex, preferring to self-stimulatewith the electrode. Initially, dopamine received all the credit for the rats’addictive, pleasure-seeking behavior. Later research revealed that the elec-trodes were stimulating more than just the brain’s dopamine supply. Theywere also triggering opiate and endorphin release in the brain.
Nevertheless, dopamine became known as a “pleasure chemical.” Cur-rently, the role of dopamine in the reward system is known to be three-fold: (1) to motivate reward pursuit, (2) to enhance learning, and (3) toconcentrate attention. Psychological effects of dopamine release in thereward system include improved mood and increased arousal. Dopaminemakes people feel good, pay attention, and feel motivated. Dopamine is re-leased in ﬁve large neural pathways, but we’ll focus solely on one in thisbook—the reward system (see Figure 4.3).
Some illicit drugs have direct effects on dopamine release and re-uptake. Cocaine and amphetamines are dopamine reuptake inhibitors.These substances prolong the release of dopamine and increase its
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FIGURE 4.3 The reward system begins as a nucleus of dopamine neurons in themidbrain and its axons travel throughout the limbic system and prefrontal cortex.
concentration in the synapses. Following long-term amphetamine or co-caine use, dopamine receptors are desensitized and one’s capacity for plea-sure and excitement are diminished (often leading to increased depressionvulnerability).
Medications that affect dopamine receptors are typically either re-ceptor blockers that prevent the transmission of dopamine signals (as inantipsychotic medications) or receptor activators. Dopamine receptor ac-tivators are used to stimulate movement and cognition in Parkinson’s dis-ease sufferers. Dopamine-activating medications can improve mood and,in high doses, trigger hypomania (a state of heightened conﬁdence andrisk taking), and even pathological gambling. In fact, pathological gam-bling is a frequently recognized side effect of a dopamine receptor (type3)–stimulating medication called pramipexole (Mirapex). Other dopamine-stimulating medications such as bupropion (Zyban, Wellbutrin), are usedas antidepressants and assist in smoking cessation. It is speculated thatbupropion decreases nicotine craving by fooling the brain into believing
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that there is enough dopamine present in the reward system, so none fur-ther needs to be released through smoking a cigarette.
The psychiatric disorder attention deﬁcit hyperactivity disorder(ADHD) is treated with dopamine-activating amphetamines (in a slow-release formulation). By increasing the brain’s supply of dopamine, chil-dren and adults with ADHD are better able to focus their attention. Long-acting dopamine agents, such as time-release amphetamines and chewedor steeped coca leaves (cocaine releasing), increase stamina, focus, andconﬁdence without as much danger of addiction as immediate-action vari-eties.
Norepinephrine
Norepinephrine was historically called noradrenaline. Norepinephrine isreleased during sudden stress. Norepinephrine itself stimulates the releaseof the stress hormone cortisol, described below. Norepinephrine causesthe rush of tension that people feel when precipitously surprised, and itprepares the body for the “ﬁght-or-ﬂight” response.
During acute stress, people experience psychological symptoms ofdecreased attention span, hypervigilance, all-or-none (black-and-white)thinking, and increased focus. Physical signs of sudden stress include in-creased heart rate, sweating, ﬂushed skin, and rapid breathing. Many ofthese symptoms are the direct result of norepinephrine release in the body.Panic is a result of sudden norepinephrine release from a deep mid-brain region called the locus ceruleus. It takes great cognitive control toprevent panicky feelings from escalating into catastrophic thinking and im-pulsive “ﬁght-or-ﬂight” behavior.
One physiologic change resulting from repeated norepinephrine re-lease is high blood pressure. High blood pressure is common on WallStreet, and it may be a sign that investors are under excessive chronicstress. Common medications used to treat high blood pressure includebeta-receptor blockers, such as propranolol. Beta-blockers act on a sub-type of norepinephrine receptor. These medications can manage both thephysical effects of chronic stress (high blood pressure) and the brain basisof acute anxiety.
According to researchers, propranolol alters risk/return perceptions inﬁnancial experiments: “Propranolol [a beta blocker] produced a selectivechange in volunteers’ decision-making; namely, it signiﬁcantly reduced thediscrimination between large and small possible losses when the probabil-ity of winning was relatively low and the probability of losing was high.”8That is