featured such celebrities as teenage Russian tennisstar Anna Kournikova. An E*TRADE advertisement claimed that “on-lineinvesting is ‘A cinch. A snap. A piece of cake.’ ”8
Former SEC chairman Arthur Levitt said, “Quite frankly, some adver-tisements more closely resemble commercials for the lottery than anythingelse. When ﬁrms, again and again, tell investors that on-line investing canmake them rich, it creates unrealistic expectations. . . . [M]any investorsare susceptible to quixotic euphoria. . .”9 New York Attorney General EliotSpitzer observed that online brokerage advertisements “convey a messageof convenience, speed, easy wealth, and the risk of ‘being left behind’ in theon-line era.”10 In a January 26, 2001, report about online trading, the SECexpressed concerns that certain types of aggressive online brokerage adsmay cause investors to possess unrealistic expectations over the risks andrewards of investing.11
THE ANATOMY OF STOCK HYPE
Lebed’s promotional messages primed readers to buy dubious investmentsby circumventing their reason and appealing directly to their neural rewardsystems. He was successful because he included the following reward sys-tem activators in his messages. Reward system provocateurs such as thoselisted below will be discussed further in this and subsequent chapters:
1. Novelty. Lebed suggested stocks in new or overlooked areas of the mar-ket, which was sure to stimulate curiosity (another function of the re-ward system).
2. Anticipation of a Large Gain. Anticipation of monetary gains acti-vates a deep, automatic area of the reward system called the nucleus
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accumbens. Lebed suggested that investors could expect a “HUGE” pay-off. Size matters to the reward system, where extremely large possiblegains override a rational ability to incorporate probability information.3. Information Overload. Lebed’s sales pitches were loaded with aplethora of corporate statistics such as projected revenues, earnings,and potential market size. For most people, a long list of detailed statis-tical information will shut down their critical faculties. Many readers ofLebed’s messages threw up their hands in exasperation, asked “What’sin it for me?,” and skipped ahead to the conclusion. Confused investorswere given a simple answer by Lebed: “Buy now, sell at $20.”
4. Bargain Buying. He appealed to investors’ search for a bargain. Heused phrases like “under book value” and “dirt cheap.” Buying some-thing at such a bargain implies that one can’t lose. On a neural level,good deals have been found to activate the brain’s reward system.
5. Author as Expert. Lebed sounded like an authority on each stock.He clearly had done some homework, and he delivered veriﬁable ﬁ-nancial data. Investors were apt to trust his projections based on hisdepth of knowledge and the thoroughness of his research. Lebed’s useof difﬁcult-to-ﬁnd data heightened his aura of authority.
6. Time Pressure. He appealed to readers’ time-discounting functions. Ifthey didn’t act “VERY SOON,” then they were going to miss out. Timepressure hinders critical analysis and causes limbic system activity tobypass the cognitive considerations of the prefrontal cortex.
In Lebed’s promotions, gullible investors were coached to anticipatelarge gains, as revealed to them by an “expert.” The hyped stock was newand interesting, and the investment required immediate action. Little down-side risk was apparent, according to the “expert.” By the time interestedpotential investors looked at the latest price quote, odds were that othereager investors (including Lebed himself) had already started buying, andtheir pressure pushed the price upwards. For an investor considering anopportunity, the idea of missing out overcomes the last remnants of resis-tance. They jumped in, and Lebed was waiting to sell to them.
GREED: THE BASICS
“An excessive desire to acquire or possess morethan what one needs or deserves, especially withrespect to material wealth.”
—The American Heritage Dictionary of theEnglish Language, Fourth Edition, 2000,Houghton Mifﬂin Company
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“An eager desire or longing; greediness; as, a greedof gain.”
—Webster’s Revised Unabridged Dictionary,1998, MICRA, Inc.
“Reprehensible acquisitiveness; insatiable desirefor wealth (personiﬁed as one of the deadly sins).”—WordNet 2.0, 2003, Princeton University
For millennia, greed has been identiﬁed as a source of ﬁnancial folly.In the Bible, as one of the seven deadly sins, greed is called avarice.The Buddha referred to greed as desire and called it the source of allhuman disappointment and suffering. Charity (the antithesis of greed)is one of the ﬁve pillars of Islam. In Victorian England, Charles Dickensparodied the greed of his character Ebenezer Scrooge, who today servesas a stark reminder of the loss of human connection that can accompanyan excessive desire for ﬁnancial gain.
Greed has been popularly portrayed in the media as a negative at-tribute. Michael Douglas, playing the ﬁctional corporate raider GordonGekko in the 1987 movie Wall Street, waxed philosophical about thetrue nature and necessity of greed before the shareholders of a corpo-ration he intended to buy, Teldar Paper. Perhaps the most memorablescene in the movie is a speech by Gekko to a Teldar Paper shareholders’meeting:
The point is, ladies and gentleman, greed is good. Greed works, greedis right. Greed clariﬁes, cuts through, and captures the essence of theevolutionary spirit. Greed in all its forms, greed for life, money, love,knowledge has marked the upward surge in mankind—and greed,mark my words—will save not only Teldar Paper but the other mal-functioning corporation called the U.S.A.
Gekko’s self-serving desire to lay-off Teldar workers and auction off itsseparate divisions for proﬁt ominously lurked beneath his claimed altruis-tic motives. Gekko’s speech was reportedly based on Ivan Boesky’s 1985commencement address to the graduates of the University of California atBerkeley, in which Boesky declared: “Greed is all right, by the way. I wantyou to know that. I think greed is healthy. You can be greedy and still feelgood about yourself.” Boesky was a Wall Street arbitrageur who was laterconvicted of federal crimes. He paid a $100 million penalty to the SEC tosettle insider-trading charges in 1986.
Economists from Adam Smith to Milton Friedman have seen greedas an inevitable and, in some ways, desirable feature of capitalism. In a
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well-regulated and well-balanced economy, greed helps to keep the systemexpanding. But it also ought to be kept in check, lest it undermine publicfaith in the entire enterprise.12
As economist Paul Krugman noted in the New York Times, the theorythat “greed is good” for society may contain a fatal ﬂaw: “A system that lav-ishly rewards executives for success tempts those executives, who controlmuch of the information available to outsiders, to fabricate the appearanceof success. Aggressive accounting, ﬁctitious transactions that inﬂate sales,whatever it takes.”13
Among investors, greed leads to ﬁnancial losses through overtrading,entering investments too late, and inadequate due diligence. It shares abiological foundation with psychological biases such as overconﬁdence,the illusion of control, and the house money effect. Greed that follows aseries of proﬁts is fuel for hubris. Broadly speaking, greed is a result ofa convergence of factors: the desire for gain, the motivation to pursueopportunities, the disregard of risks, and a penchant for excess.
On an individual level, greed has deleterious effects on performance,yet greed is a common facet of human behavior. Can learning about greedimprove one’s proﬁts in the markets (to be sure, a greedy motivation)? Formany investors, locating stocks with large proﬁt potential and anticipat-ing their high returns is one of the exciting (and occasionally addictive)aspects of investing. Managing the greed that accompanies a normal in-vestment process is an enduring challenge.
In order to understand the type of greed that drives investors to fallfor pump-and-dump scams, chase fast-moving stocks, and otherwise takeexcessive risk, it’s revealing to look inside the brain. Neuroimaging showshow greed arouses the neural circuitry, what types of information intensifygreed, and which interventions appear to rein it in.
THE BIAS TASK
Studies by researchers at Stanford University have revealed some ofthe brain origins and expensive consequences of greed. The researchershave identiﬁed a part of the brain that generates excitement about po-tential gains, occasionally leading to excessive ﬁnancial risk seeking.Additionally, they found that a different area of the brain is activated wheninvestors fear loss, and that area powers excessive ﬁnancial risk aversion.Such neuroimaging studies greatly simplify the investment decision-making process due to experimental constraints. Nonetheless, they haveprovided deep insight into how investors assess and choose investmentoptions.
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Since 1999, professor Brian Knutson has performed brain imaging ex-periments that illuminate the characteristics of an emotional state calledpositive activation. Positive activation refers to the excited anticipationof a good outcome. Some positive emotions, such as comfort and satis-faction, are not associated with arousal. Other positive emotions, such asexcitement and elation, consist of both positive emotion and physiologicalarousal (activation). Experimentally, an excellent way to induce positiveactivation is to offer subjects money.
In his ﬁrst experiments, Knutson found that different regions of thebrain’s reward system were activated at different times during ﬁnancialgambles. In particular, he found that anticipating ﬁnancial gains activateddifferent reward system centers than when those gains were received. Adeep brain area called the nucleus accumbens (NAcc) (see Figure 7.2 onpage 101) was primarily activated by reward anticipation. An area of themedial prefrontal cortex (MPFC) (see Figure 8.1a and b on page 113), justbehind the eyes in the midline, was activated when monetary rewards werereceived.
In subsequent experiments, Knutson localized areas of the reward sys-tem that are activated during anticipation of different-sized gains. As thesize of a potential reward increases, the NAcc is increasingly activated. Healso identiﬁed the brain area where the probability of receiving a reward isencoded. As the probability of getting a reward increases, the MPFC is in-creasingly activated. Through 2004, Knutson’s studies revealed how peopleanticipate and learn about ﬁnancial rewards when the magnitudes, proba-bilities, and expected values of those rewards change.
In 2005, Stanford ﬁnance graduate student Camelia Kuhnen (now as-sistant professor at Northwestern University–Kellogg School of Manage-ment) designed a study with Knutson to discern how individuals decideto take investment risk. She hypothesized that areas of the reward systemmight drive excessive risk taking and risk avoidance. Kuhnen and Knutsonreﬁned an investment experiment in which they could visualize the mo-ment of decision making. Their study was the ﬁrst using functional mag-netic resonance imaging (fMRI) to visualize brain activity during invest-ment decisions.14
In their experimental task, called the Behavioral Investment AllocationStrategy (BIAS) task, Kuhnen and Knutson asked subjects to make an in-vestment choice among three alternatives. Two of the alternatives wererisky “stocks” (either “Stock A” or “Stock B”), and one was a “bond.” Af-ter the subjects selected one of the three choices, the results of each optionwere revealed to the subjects. If the subjects had made money, it was addedto their account, but if they lost money, it was subtracted.
One of the two stocks had a net positive payoff over the 10 trials,and the other had a net negative payoff. At the beginning of each blockof 10 trials, subjects did not know which stock was proﬁtable or which
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was money losing, so they learned via trial and error. The “good” stock hada random payoff distribution of +$10 (50 percent likelihood), $0 (25 per-cent), and –$10 (25 percent), for an expected value per trial of $2.50. The“bad” stock had payoffs of +$10 (25 percent), $0 (25 percent), and –$10(50 percent), for an expected value per trial of –$2.50. The only differencebetween the two stocks was a 25 percent shift in the likelihood of the high-est value (+$10) and lowest value (–$10) outcomes. The third choice, thebond, yielded a constant return of $1 per trial.
Potential Choice Payoffs of the BIAS Task
= $1 per trial
BondStock A = Averaged either +$2.50 or –$2.50 per trialStock B = Averaged either +$2.50 or –$2.50 per trial
While subjects’ goal in the BIAS task was to make as much money aspossible (they kept their earnings), they did not know which stock was thehigh-paying one when they ﬁrst begin playing the game. After watching thepayoff of each stock over several trials, subjects would develop a greatersense of certainty about which was the “good” one. To prevent the subjectsfrom always knowing which stock was best, after 10 trials the stocks wererandomized and a new block of 10 trials initiated.
Dear Reader: If you’re feeling mathematically inclined, decidehow you would choose in this experiment. Would you start outchoosing a stock? If not, how would you proceed? After howmany trials would you know with some certainty which was thehigh-payoff stock? (Do this quickly before reading on.)
As the ﬁrst few trials pass, subjects can generate a probabilistic senseof which stock is high paying and which is not. One should optimally beginto choose the “good” stock when 70 percent certain of its identity, in orderto maximize expected value. After each trial, you can calculate the oddsthat a stock is the “good” stock using Bayes’s theorem. Subjects madedecision “mistakes” when they did not follow Bayes’s theorem as theyattempted to maximize their proﬁts. Of course, it was impossible for thesubjects to mentally calculate Bayesian probabilities in the limited timeprovided, so they had to rely on general impressions, and they made manymistakes.
In “risk-aversion” mistakes, subjects would choose the bond eventhough they had enough information to know which stock was the “good”stock with at least 70 percent probability. Activation in an area of the braincalled the anterior insula predicted risk-aversion errors (see Figure 7.1) inthis experiment.
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FIGURE 7.1 These images demonstrate the location of the insula. Note that theanterior insula is the forward portion. The insula is an evolutionarily older type ofcortex. Newer cortex (neocortex) tissue in the temporal and parietal lobes folds inover the outside of the insula. Activity of the anterior insula is associated with theexperience of pain and predicts risk-aversion mistakes in the BIAS task.
In fMRI experiments by other researchers, the anterior insula was acti-vated by pain, loss, and disgust. Kuhnen and Knutson noticed that subjects’anterior insulas were activated when they learned they hadn’t chosen themost lucrative option. When such a “counterfactual loss” occurred, theywere more likely to jump to the bond (thus making a risk-aversion mis-take). It should have been apparent to the subjects that, given the odds, the“good” stock would occasionally pay less than the “bad” stock. Nonethe-less, subjects had difﬁculty sticking with the “good” stock after a counter-factual loss.
Some subjects who had performed well in the ﬁrst portion of an experi-mental block became more conservative toward the end, apparently fearfulthat they might “give back” some of their winnings. This is a type of risk-aversion mistake (called “cutting winners short”) that is discussed in Chap-ters 14 and 15. Experiencing a counterfactual loss (in the ﬁrst example) oraccumulating large proﬁts (in the second) predicted subjects would choosethe safety of the bond, thus making a risk-aversion mistake. The subjects’anterior insulas became activated just before they made the switch to amore conservative, risk-averse strategy.
Investors who sell their long-term investments after a brief period ofunderperformance are demonstrating risk aversion. Additionally, investorswho sell a rising stock, effectively “cutting a winner short,” may similarlybe displaying insula-driven risk aversion.
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THE NUCLEUS ACCUMBENS
In the BIAS task, when subjects invested in one of the stocks before theywere 70 percent sure that it was the “good” stock, they committed what iscalled a risk-seeking mistake. Kuhnen and Knutson found that the NAccof the reward system was activated before subjects made risk-seeking mis-takes, thus predicting the mistake that subjects were about to make (seeFigure 7.2).
The nucleus accumbens is well known among neuroscientists due to
several interesting characteristics:
1. The Pleasure Center. Neurosurgeons found that people undergoingsurgery reported intense sensations of well-being (and some had or-gasms) when electrically stimulated in the NAcc.16 More recently, sci-entists demonstrated that NAcc activation is correlated with subjectivereports of positive emotionality.17 While pleasure is undoubtedly onefunction of the NAcc, there are other functions such as motivation andlearning that are also of interest to neuroscientists.
2. Drug Abuse. All drugs of abuse activate dopamine neurons in thereward system, which has terminals in the NAcc. Thus, the NAcc isthought to be the brain center responsible for drug craving.
3. Reward Anticipation. The NAcc is activated on fMRI scans when peo-ple are anticipating or expecting to make money.18 Other rewards can
FIGURE 7.2 These are images of nucleus accumbens (NAcc) activation. Activityof the NAcc is associated with the experience of positive excitement and predictsrisk-seeking mistakes in the BIAS task.
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activate the NAcc, such as chocolate, luxury items, and pornographicpictures.
Activation of the NAcc does not in itself predict risk-taking mistakes.Rather, it is excessive activation, as compared to baseline, that correlateswith investment decision errors. “On average, the participants in the studymade rational choices 75 percent of the time and made mistakes 25 per-cent of the time,” according to Knutson in the article’s accompanying pressrelease, “and the brain areas lit up even when rational choices were beingmade, just not as much.”
Some businesses use cues or triggers in order to activate customers’risk-taking brain regions to induce them to take more ﬁnancial risk. PerKnutson in the press release, his ﬁndings “may also explain why casinosemploy ‘reward cues’ such as free drinks and surprise gifts as anticipationof other rewards that may activate the NAcc and lead to changes in be-havior. . . . Insurance companies might employ the opposite strategy, usingstrategies that would activate the anterior insula.” From the previous dis-cussion of brokerage advertising during the late 1990s, it is clear that suchcues have been used widely in the ﬁnancial industry to encourage invest-ment risk taking.
Investors are experiencing NAcc activation when they feel excitedabout “hot” stock investment opportunities. Stocks in new or high-growthindustries and those with lucrative-sounding stories trigger NAcc activa-tion and the experience of greed for gain.
EXCITED ABOUT A GOOD DEAL
The BIAS task demonstrated how “irrational” risk-taking decisions couldbe predicted by watching changes in brain activation. Researchers thenturned their attention to the mechanics of the “buy” decision in a re-tail environment. Professor Knutson, Professor George Loewenstein (atCarnegie Mellon University), and others designed an experiment to mea-sure whether there is a “buy signal” in the brain. Speciﬁcally, are therebrain areas that drive purchases of consumer items?
In the experimental task, the researchers displayed a number of rou-tine consumer products (such as a box of Godiva chocolates, an MP3player, or a Dodgeball DVD). Alongside the items they posted the pricesat which subjects could buy them from the researchers. Interestingly, theprices of the items had been discounted approximately 70 percent fromtheir retail prices. The discount was necessary because subjects had beenunwilling to buy the items near the full retail price.
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Knutson found that activity in three brain regions predicted purchas-ing decisions. Activity in the NAcc was associated with a preference for aproduct (a desire to possess it), and predicted that the participant wouldbuy the item. The participants’ MPFC was activated when prices werevery cheap, and its activation also predicted that the subjects would buy.Decreased activity in the brain’s pain center, the insula, occurred duringthis experiment, and this decreased activity also predicted buying. In con-clusion, it appears there are three neural predictors of buying consumeritems—desire for the product (increased NAcc), a cheap price for theproduct (increased MPFC), and little perceived risk (decreased anteriorinsula).15
There are several speculative applications of these ﬁndings to invest-ment practitioners. The satisfaction value investors feel as a result of hunt-ing for bargain-priced stocks may be due to MPFC activation. It’s possiblethat value investors such as Warren Buffett, David Dreman, and Bill Millerare tuned in to “bargain” signals from their MPFCs.
Stock investors who look for an exciting or desirable story may bebuying stocks based on NAcc activation. These are the investors who buystock in a “good company” that they like, forgetting that a good companydoes not equal a good stock.
Investors who see little risk in an investment are driven to buy by theabsence of a perceived “downside” (decreased anterior insula activation).Because they don’t see how they could lose, they are more willing to takea risk and buy. The MPFC, NAcc, and insula are all part of the neural cir-cuitry with which investments are evaluated. Interestingly, patterns in theiractivation also predict purchase decisions.
IMPROVING BIASED DECISION MAKING
Emotions are part of both rational and irrational choice behavior. It’s theextremes of emotion that lead to excess. Intense emotions, such as greedand fear, are indicators that one is susceptible to the risk-aversion and risk-seeking mistakes seen in the Kuhnen and Knutson study.
People can use the physical signs of emotion (feelings) as signals forwhen they are likely to make errors in their investment decision mak-ing. Using feelings as predictive signals requires a high degree of self-awareness. Self-awareness of feelings and consciously monitoring recentdecisions for emotional inﬂuences can signiﬁcantly improve decision mak-ing. Deliberate action to interrupt emotional decision making, even some-thing as simple as taking a deep breath, may be the most efﬁcient means forreducing excessively emotional decision making. The real message may be
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a common-sense one: Whenever you’re facing a big decision, and you feelexcited, step back a moment and think it over.
For example, if an investor has experienced a recent loss and notesthat he is either feeling nervous or exhibiting signs of irrational risk avoid-ance behavior such as (1) hesitating in entering new positions, (2) delib-erating about further potential losses, or (3) seeing more ﬁnancial threatsthan usual, then he is experiencing excess anxiety. He should identify thatanxiety is the origin of his decision problems and take action to either re-duce the anxiety or bolster his self-discipline.
Conversely, if an investor has recently made large gains and is feeling(1) celebratory, (2) infallible, and (3) like taking more risk, then he ought totake a step back. Is he focusing solely on potential returns while ignoringprudent risk control? If so, then steps should be taken to reinforce invest-ment discipline.
GREED IN THE MARKETS
“I will tell you how to become rich. Close the doors.Be fearful when others are greedy. Be greedy whenothers are fearful.”
—Warren Buffett, lecturing to a group of studentsat Columbia University (he was 21 years old)
One proxy for excessive emotionality is the language that investors useto describe their investments and the current market conditions—their ver-bal framing of the investment climate. If investors express themselves ina negative emotional tone, then they are likely to be feeling risk averse.However, when investors use positive words to express their market sen-timents, they are more likely to be taking excessive risk. A simple way totest this hypothesis is to count the number of negative and positive wordsin the media.
In May 2005, I counted such words using the online transcripts ofthe television business news programs Nightly Business Report with PaulKangas and CNN’s Moneyline with Lou Dobbs. Moneyline’s transcripts ranfrom January 3, 2000, to June 12, 2003, while NBR’s are available from Jan-uary 3, 2000, up until this writing. When the number of positively and nega-tively toned words are summed, one can get a pretty consistent idea of theamount of negativity and positivity in the business news during any givenbroadcast.
I ran a simple linear regression to see if there is a correlation betweenthe number of positive or negative words and the future market direction.
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It turns out that when there is a high frequency of positive words, the stockmarket (S&P 500) is more likely to decline over the following week. Thereverse pattern is true using negative words—a high frequency of negativewords precedes market advances. While interesting, these patterns do notlead to investment proﬁts due to transaction costs.
Based on this informal language study, the “sentiment” of the media ap-pears to reﬂect the risk perceptions of the average investor. During highlynegativistic business news broadcasts, the average investor will feel theemotional inclination to be risk averse, but in fact would have greater long-run proﬁtability if she were buying stocks during those times. The oppositepattern is true during excessively positive newscasts.
These ﬁndings seem to support advice Warren Buffett wrote to a hy-pothetical market timer in the 2004 Berkshire Hathaway annual newslet-ter: “And if they insist on trying to time their participation in equities, theyshould try to be fearful when others are greedy and greedy when others arefearful.”
The next chapter looks at the effects of overconﬁdence and hubris on in-vestor decision quality.
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C H A P T E R 8
Overconﬁdenceand HubrisToo Much of a Good Thing
“The line separating investment and speculation,which is never bright and clear, becomes blurredstill further when most market participants haverecently enjoyed triumphs. Nothing sedates ratio-nality like large doses of effortless money. Aftera heady experience of that kind, normally sensi-ble people drift into behavior akin to that of Cin-derella at the ball. They know that overstaying thefestivities—that is, continuing to speculate in com-panies that have gigantic valuations relative to thecash they are likely to generate in the future—willeventually bring on pumpkins and mice. But theynevertheless hate to miss a single minute of whatis one helluva party. Therefore, the giddy partici-pants all plan to leave just seconds before midnight.There’s a problem, though: They are dancing in aroom in which the clocks have no hands.”
—Berkshire Hathaway 2000 Annual Report,February 28, 2001
Victory disease refers to the tendency for military commanders, after
a series of triumphs in the ﬁeld, to subsequently demonstrate poorjudgment. The fortunes of victors reverse due to arrogance, compla-cency,