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Inside theInvestor’sBrain
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Founded in 1807, John Wiley & Sons is the oldest independent publishingcompany in the United States. With ofﬁces in North America, Europe, Aus-tralia and Asia, Wiley is globally committed to developing and marketingprint and electronic products and services for our customers’ professionaland personal knowledge and understanding.
The Wiley Trading series features books by traders who have survivedthe market’s ever-changing temperament and have prospered—some byreinventing systems, others by getting back to basics. Whether a novicetrader, professional, or somewhere in between, these books will providethe advice and strategies needed to prosper today and well into the future.For a list of available titles, visit our Web site at www.WileyFinance.com.
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Inside theInvestor’sBrain
The Power of MindOver Money
RICHARD L. PETERSON
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Copyright C(cid:2) 2007 by Richard L. Peterson. All rights reserved.
Published by John Wiley & Sons, Inc., Hoboken, New JerseyPublished simultaneously in Canada.
Wiley Bicentennial Logo: Richard J. Paciﬁco
No part of this publication may be reproduced, stored in a retrieval system, or transmitted in anyform or by any means, electronic, mechanical, photocopying, recording, scanning, or otherwise,except as permitted under Section 107 or 108 of the 1976 United States Copyright Act, withouteither the prior written permission of the Publisher, or authorization through payment of theappropriate per-copy fee to the Copyright Clearance Center, Inc., 222 Rosewood Drive, Danvers,MA 01923, (978)750-8400, fax (978) 646-8600, or on the Web at www.copyright.com. Requests tothe Publisher for permission should be addressed to the Permissions Department, John Wiley &Sons, Inc., 111 River Street, Hoboken, NJ 07030, (201) 748-6011, fax (201) 748-6008, or online athttp://www.wiley.com/go/permissions.
Limit of Liability/Disclaimer of Warranty: While the publisher and author have used theirbest efforts in preparing this book, they make no representations or warranties with respectto the accuracy or completeness of the contents of this book and speciﬁcally disclaim anyimplied warranties of merchantability or ﬁtness for a particular purpose. No warranty may becreated or extended by sales representatives or written sales materials. The advice and strategiescontained herein may not be suitable for your situation. You should consult with a professionalwhere appropriate. Neither the publisher nor author shall be liable for any loss of proﬁt or anyother commercial damages, including but not limited to special, incidental, consequential, orother damages.
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Library of Congress Cataloging-in-Publication Data
Peterson, Richard L., 1972-
Inside the investor’s brain : the power of mind over money / Richard L. Peterson.
p. cm. – (Wiley trading series)
Includes bibliographical references and index.ISBN-13: 978-0-470-06737-6 (cloth)1. Investments–Psychological aspects.
I. Title.
HG4515.15.P48 2007332.601(cid:3)9–dc22
Printed in the United States of America
10 9 8 7 6 5 4 3 2 1
2006103091
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To Sarah.
Your grace, warmth, and ease light up my world.
You made this book possible.
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Contents
Preface
Acknowledgments
About the Author
Introduction
PART I
Foundations
CHAPTER 1 Markets on the MindAnalysts and Dart Boards
Developing Better Expectations
“The Wisdom of the Collective”
Meteorological Anomalies and Other
Animal Spirits
Sentiment
CHAPTER 2 Brain BasicsDamasio and the Iowa Gambling Task
The Brain: Structure and Function
The Brain-Damaged Investor
Research Methods
Neuroscience Preview
CHAPTER 3 Origins of MindEmotions and Perceptions
Expectations and the Comparator
Counterfactual Comparisons
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INSIDE THE INVESTOR’S BRAIN
Beliefs and Expectations: The Placebo Effect
Making Sense of the News
Self-Deception
Emotional Defense Mechanisms and
Motivated Reasoning
CHAPTER 4 NeurochemistryIntroducing the Neurotransmitters
Serotonin
Dopamine
Norepinephrine
Opiates
Stress Hormones
Caffeine
GABA, Acetylcholine, and Omega-3 Fatty Acids
The Chemistry of (Financial) Mental Disorders
The Neurochemistry of Financial Performance
Serotonin and Market Bubbles
Recreational Drugs and Alcohol
Alcohol
Cocaine
PART II
Feelings and Finances
CHAPTER 5 IntuitionAnalysis and Intuition
Investment Practice
What Does Your “Gut” Tell You?
Listening Without Thinking
Intuition and Emotion in Investing
Emotional Intelligence
Subliminal Emotion
Stirring the Unconscious
CHAPTER 6 Money EmotionsEmotional Biases
The Difference between Positive and Negative Feelings
Regret as a Self-Fulﬁlling Prophecy
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Contents
An Amicable Divorce
Sadness and Disgust
Fear and Anger
Projection Bias
Managing Feelings
Summary
CHAPTER 7 Excitement and GreedBrokers Kindle Irrational Exuberance
The Anatomy of Stock Hype
Greed: The Basics
The BIAS Task
The Nucleus Accumbens
Excited About a Good Deal
Improving Biased Decision Making
Greed in the Markets
CHAPTER 8 Overconﬁdence and HubrisThe Psychology of Hubris
Overconﬁdence
Illusion of Control
Winning Changes the Brain
The Neurochemistry of Exploration
One Who Knows: Christian Siva-Jothy
Conﬁdence—the “Good” Kind
Solutions
CHAPTER 9 Anxiety, Fear, and NervousnessClimbing a Wall of Worry
Dread in the MRI
Nature versus Nurture
It’s All in Your Head
Empathy Gaps
Pain Relief
Investment Lessons
Of Hurricanes, Risk Perceptions, and Opportunity
Summary
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INSIDE THE INVESTOR’S BRAIN
CHAPTER 10 Stress and BurnoutStress
Cramer on Stress
Choking for Rupees
Which Goes Wrong—the Brains or the Brawn?
Stress and Trend Perception
Neurochemistry of Stress
Biological Effects of Stress
Adrenaline Junkies
Managing Investment Stress
Summary
CHAPTER 11 Love of RiskKnowing When to Fold ‘Em
Pathological Gambling
The Gambler’s Brain
Ought to Know Better
Reducing Gambling
Summary
CHAPTER 12 Personality FactorsThe “Big Five”
Extraversion versus Introversion
Neuroticism versus Emotional Stability
Conscientiousness versus Impulsiveness
Openness to New Experiences versus Traditionalism
Agreeableness versus Self-interest
The Genetics of Personality
Investing Personality
Neurotic Investors
Extraverted, Open, and Conscientious Investors
Other Personality Research
Trading Psychology
PART III Thinking about Money
CHAPTER 13 Making DecisionsExpected Value and Expected Utility
The Jackpot Trap
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Contents
Probability Misjudgments
Vividness, Imagination, and Desire
Ambiguity and Uncertainty
Ambiguity in the Markets
Neuroscience of Ambiguity, Risk, and Reward
The Possibility that You are Overweight
The Trusting Brain
Neuroscience of the Ultimatum Game
The Trust Hormone
Implications
CHAPTER 14 Framing Your OptionsThe Disposition Effect
A Father-Son Stock Sale
Teasing out the Problem
Framing Risk
A Frame in the Membrane
Holding Losers: “Double-or-Nothing!”
Differences in Aversion
Letting Winners Ride
Summary
CHAPTER 15 Loss AversionNeuroscience of Loss Aversion
The Equity Premium Puzzle
The Implied Put Option
Overcoming Loss Aversion
The House Money Effect
Lessons from the Pope
Comments from Soros, Tudor, and
Cramer: “Booyah!”
CHAPTER 16 Time DiscountingGet Your Hand out of the Cookie Jar
Brain Basis of Delayed Gratiﬁcation
Chemical Impulses
Monkey Business
Making a Killing in the Options Pit
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INSIDE THE INVESTOR’S BRAIN
Improving Self-Control
In Practice
CHAPTER 17 HerdingHerding
Social Proof
Social Comparison
Asch and Conformity
Information Cascades
Stanley Milgram and the Shocking Truth
Nice Clothes, Fast Cars, and Fancy Titles
The Neuroscience of Cooperation
Analysts’ Abuse of Authority
The Herding Habit
Living the Contrarian Lifestyle
Advice for Herd Animals and Trend Followers
Advice for Investment Committees
CHAPTER 18 Charting and Data MiningArtiﬁcial Neural Networks
Data Mining and Self-deception
Finding Patterns in the Noise
The Trend and Mean-reversion Biases in Chart Reading
Overreliance on Charts
The Gambler’s Fallacy
Irrational Exuberance . . . Called Too Early
The Soochow Gambling Task
The Learned Caudate
Patterns in Earnings Reports
Fooled by Randomness
CHAPTER 19 Attention and MemoryTerminal Illness
Representative Returns
Fond Memories
Beating the Hindsight Bias
Attention Deﬁcit
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Contents
Keep Your Eye on the Pills
What’s in a Name?
China Prosperity Internet Holdings
“All that Glitters”
CHAPTER 20 Age, Sex, and CultureEmotional Memories
The Female Brain: Estrogen, Emotion, and Cooperation
Financial Planning for Divorcees
Male Overconﬁdence
Age
The Seattle Longitudinal Study of Adult Development
Culture (East and West)
Chinese Risk Takers
Biases Among Chinese Stock Traders
PART IV In Practice
CHAPTER 21 Emotion ManagementDo it for Love, Not Money
Money Changes You
Emotional Defenses
The Pursuit of Happiness
Neuroplasticity
Chemical Stabilizers
Self-discipline
Creating a Decision Journal
CHAPTER 22 Change TechniquesDealing with Fearful and Overconﬁdent Clients
Cognitive-behavioral Therapy and Stress Management
Yoga, Meditation, and Lifestyle
Simple Stress Reduction
Getting Out of a Slump
Trading CoachesFlavia Cymbalista
Denise Shull
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INSIDE THE INVESTOR’S BRAIN
Modeling Others
Growing Happier
Neurofeedback
Maintain “Learning Goals”
CHAPTER 23 Behavioral Finance InvestingHarvesting Risk Premia
Risk Premia and Expectations
Value versus Glamour
Momentum, Size, and the Optimal Portfolio
“Buy on the Rumor and Sell on the News”
Limits to Arbitrage
Behavioral Finance Fund Performance
Behavioral Investment Products
Final Notes
Notes
Glossary
Index
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Preface
T his book isn’t written for you. At least, it’s not intended for the rational,
thinking you who was thrown off by that last sentence. This book isfor the parts of you that were perturbed, the feelings that you can’tquite access. Those feelings arise from deep in your brain, and they’re largelysubconscious. To get to them, I have to go through you—you the reader.
And there’s the catch. If thinking could make everyone a great investor,then there wouldn’t be market bubbles and panics, poverty, addiction, orcriminal greed. But we do have those problems—in part because the think-ing brain evolved about 100,000 years ago, while the feeling brain is one ofour most primitive endowments (something we share with our pets), andthe two brains don’t always get along. How to manage them both in the wildworld of the ﬁnancial markets is the subject of this book.
In the ﬁnancial industry, most investment decision making follows arational process until, often at crucial times, that process breaks down.Whether you’re an individual investor, portfolio manager, ﬁnancial adviser,trader, analyst, or member of an investment committee, odds are you’veexperienced the powerful effects of the psychological forces that move themarkets. This book answers two questions for investors: What are the deep“irrational” forces driving investment behavior, and what can be done tobetter manage them?
GOOD INVESTING IS MORE THANBOOK SMARTS
Good investing requires a basic ﬁnancial education. That’s the straightfor-ward part. However, to really excel in investing, you’ve got to learn the skillsto manage yourself. Book smarts aren’t enough. You’ve got to understandboth the terrain of the markets and the topography of your mind.
This book is intended for educated investors (individuals, portfoliomanagers, venture capitalists, and bankers), ﬁnancial analysts (security re-search, fundamental and technical analysts), and traders. Readers of this
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INSIDE THE INVESTOR’S BRAIN
book will learn to identify subconscious mistakes (biases) in their ﬁnancialdecision making. Readers will develop an understanding of the brain ori-gins of psychological biases, learn to recognize when they arise, and gaintechniques for improving their ﬁnancial judgment.
However, just because you know when you’re likely to make a mistakedoesn’t mean you can stop yourself from doing it. Two methods are effec-tive for learning to manage biases: personal experience and studying theexamples of others. Gaining personal experience in the markets is costly.To enhance the study of others, this book contains examples of investorswho have succumbed to biases, people who have overcome such mistakes,the decision-making tactics of great investors, and tips for creating an in-vestment environment that supports effective decision making.
Much of the research on investor biases presented here is imported fromthe academic ﬁeld of behavioral ﬁnance. Investigators in behavioral ﬁnance,in pioneering studies, have identiﬁed numerous systematic investing biases.Due to their origination in deep brain circuits, most biases inﬂuence invest-ment decisions automatically and beneath awareness. When evidence fromneuroscience, behavioral ﬁnance, and real-world practitioners is integrated,then a clearer picture of the fundamental issues and remedies is revealed.
ORGANIZATION OF THIS BOOK
Most chapters open with vignettes. Some are tragic, some uplifting, andsome unusual. All are selected for the lessons they teach. The investorsdepicted in these stories are fabricated from my collective experiences withnumerous individuals and through anecdotes I have heard from others. Anyresemblance to real persons is completely coincidental.
In individual chapters, readers will learn to: (1) identify speciﬁc sub-conscious biases, (2) know when thinking and analysis will improve theirinvestment process (and when it won’t), (3) improve their emotional aware-ness, and (4) enhance the decision process.
One caveat: There is an emphasis on the neural origins of biases, yet fewdirect links between the brain and investment behavior have been proven.Nonetheless, this book attempts to simplify concepts and relationships asaccurately as possible to make the discussion relevant to practitioners. Inthe introduction, the investment fallibility of Long-Term Capital Manage-ment, Sir Isaac Newton, and Samuel Clemens (Mark Twain) are used toillustrate some of the most basic and prevalent investor biases. Chapter 1explains the challenges investors face in ﬁnding opportunities in a competi-tive marketplace, and it argues that the best remaining source of proﬁts liesin understanding how other investors think. Chapter 2 educates the reader
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about basic brain structure and brieﬂy reviews the research tools used inexperiments. Chapter 3 describes the roles of belief and expectation in shap-ing one’s experience. Chapter 4 is a discussion of neurochemistry includingthe common medications and substances that alter neurochemical balanceand inﬂuence ﬁnancial decision making.
Part II describes how various emotions impact judgment. Chapter 5demonstrates the tremendous value of intuition and “gut feel” in investmentdecisions. Chapter 6 explains how overt emotions such as fear, excitement,anger, and sadness bias ﬁnancial judgment. Chapter 7 looks at the brainorigins and pathological investment effects of excessive greed and excite-ment. Chapter 8 examines the dangers presented by overconﬁdence andthe hubris that results from a series of successes. Chapter 9 describes howanxiety and fear affect investor decision making, while Chapter 10 is speciﬁ-cally about stress and burnout. Chapter 11 describes pathological gambling,which affects some day traders and institutional “rogue traders.” Chapter12 investigates the personality traits that contribute to investing excellence.Part III is a review of the cognitive (thinking and perception) biases.While these biases are inﬂuenced by emotion, research has primarily fo-cused on the mental mechanisms that underlie them. Chapter 13 brieﬂyexplains modern decision-making theory, and illustrates how informationabout outcome size, probability, and ambiguity biases choice. Chapter 14investigates how the framing of a decision biases judgment. Chapter 15explains loss aversion – which results in “holding losers too long” – bothin amateur and professional investors. Chapter 16 is a discussion of howtime perception, such as time discounting, generates investment biases.Chapter 17 is about the process of social inﬂuence and herding, and how itimpacts investment decision making and investment committees. Chapter18 explains the perceptual pitfalls that arise during chart reading and datamining. Chapter 19 is a discussion of biases in attention and memory thataffect investors. Chapter 20 looks at investment risk taking from the per-spective of the differing biology of women versus men and the aged versusthe young. It also examines the (very limited) cultural differences betweenEastern and Western investors.
Part IV presents techniques for managing biases. Chapter 21 summa-rizes the book’s major conclusions and offers self-help exercises for re-ducing biases. Chapter 22 provides a more in-depth approach to emotionmanagement in the markets. Chapter 23 teaches the reader how to incor-porate “neural” insights into their investing strategy and explains how toidentify and take advantage of collective biases in market prices.
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Acknowledgments
I wrote this book over several years. So many people inﬂuenced its pro-
duction that I cannot possibly do justice to their contributions here. I amvery appreciative of my family and friends, who provided their love andencouragement. Thanks especially to Sarah, my amazing wife, for her un-ﬂagging optimism and patience during the writing of the book. My gratitudeis profound.
I am extremely indebted to the efforts of hundreds of researchers andresearch assistants whose experiments form the basis of this book’s content.Without their dedication and passion, human knowledge would not advance.Many scientists shared their ideas in countless hours of fascinating dis-cussions, most of which made it into the book in spirit, if not explicitly. BrianKnutson has been an extraordinary mentor to me, and the completion ofthis book would never have been possible without the time I spent learningfrom him. I have many neuroscientists to thank. Ching-Hung Lin graciouslyprovided his lab’s fascinating data on the Soochow Gambling Task. CarrieArmel taught me the basics of facial EMG. I’d like to express my gratitudeto Paul Zak for sharing his macro insights into the intersection of economicbehavior and individual biology. Hilke Plassman, Scott Huettel, Paul Slovic,Greg Berns, Elke Weber, Ernest Barratt, and Jamil Bhanji were encouragingand generous with their time during our long discussions and interviews.
On the ﬁnance side of the aisle, special thanks to Richard Peterson(my father), who introduced me to the markets at an early age and withwhom I’ve had hundreds of enjoyable ﬁnancial discussions over the years.Camelia Kuhnen kindly shared insights into the limitations and strengths ofbehavioral ﬁnance and neuroﬁnance. Hersh Shefrin, Mark Seasholes, DavidLeinweber, Zhaohui Zhang, Andrew Lo, and Hank Pruden helped me gainan (admittedly still feeble) grasp of the basics of modern behavioral ﬁnanceand behavioral investment strategy. Bob Olsen has made an extraordinarycontribution to this book through his editorship of the Journal of Behav-ioral Finance, whose articles provide numerous insights into the real-worldeffects of psychological biases.
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Investing psychologists Frank Murtha, Doug Hirschhorn, Denise Shull,Flavia Cymbalista, Alden Cass, and Janice Dorn shared fascinating storiesand insights from their practices. Performance psychologist and coach,Howard Fleischman, provided valuable advice during the preparation ofthe self-help chapters.
Michael Mauboussin illuminated some of the psychological realitiesof fund management through our fascinating discussions and his excellentbooks and articles. I am very grateful for insights from ﬁnancial practitionersincluding David Strong, Martin Auster, Carlo Cannell, Patrick Acasio, RafaelDrouhy, Sean Phelan, Faris Hitti, Dan Beale, John Cammack, Bill Miller,Arnold Wood, Dan Case, and Emily Wong. They contributed an essentialapplied perspective to this book. Numerous ﬁnancial advisers also providedinsights, including Shirley Mueller, Ken Winans, Michael Lauren, SantoshKeni, Adil Yousufzai, Michael McDonough, Nitin Birla, and Andy Byer.
Tom Samuels has been an optimistic and enthusiastic friend, psy-chotherapy mentor, and supporter since I ﬁrst overconﬁdently told himI could write this book in 40 hours. Richard Friesen has been inspiring, hon-est, and helped me remain grounded since the beginning. Without the kindprompting and patience of Emilie Herman at Wiley, this book would nothave been. Pamela van Giessen and Bill Falloon gave me my “big break” inwriting this book, and Christina Verigan at Wiley helped keep me on track.And a ﬁnal thank you to the investors who have shared their personalstories with me. They must remain nameless. Whether through their tragicdisappointments or spectacular successes, they inspired my search for aroad-map to the investor’s mind. I hope that by sharing their stories, thosewho follow can avoid their dangerous ﬁnancial wrong turns and model theirhigh-performance secrets.
R.L.P.
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About the Author
R ichard L. Peterson is founder of Market Psychology Consulting,
where he trains ﬁnancial professionals for improved performance.Dr. Peterson has developed ﬁve psychological testing products in-cluding the “Money and Investing Personality Test.” He is currently devel-oping analytical market software and novel investment strategies for use inportfolio management.
Dr. Peterson received a BS in electrical engineering and a BA in PlanII Arts at the University of Texas in 1995. In 2000 he received a doctor ofmedic