that he was away, computerized trading robots hadcompletely taken over his prior trading strategies. Automated softwareagents could screen far more market price information than a humancould, not to mention the extreme speed with which they could enter or-ders (measured in milliseconds).
Collin found work as a institutional trader for a Bay Area hedge fund.He stopped practicing mindfulness mediation, and some of his inatten-tiveness reemerged. As Collin put it, “There’s something about staring atthat screen all day—it changes me.” Collin’s story illustrates the effects oftrader attention burn-out.
TERMINAL ILLNESS
Most trading desks are backed by a wall of liquid crystal display (LCD)monitors and television screens. Some of the traders intensely watchingthose monitors are unknowingly changing their neurochemistry. Studiesof children and television watching indicate that increased daily televi-sion viewing time correlates with decreased attention span. American chil-dren aged one year old watch an average of 2.2 hours and children threeyears old watch 3.6 hours of daily television. For each hour above aver-age that children watch TV at these ages, there is a 10 percent increasein the rate of diagnosed attention deﬁcit–hyperactivity disorder (ADHD)when these children turn seven years old. This result is independent of theeffects of home cognitive environment. In children, watching excessive TVreduces attention span. Is this true for traders? For some, yes, but deﬁnitelynot for all.
If television is such an attention drain, what about computer monitors?Adolescents who spend more hours on their computers are more likelyto be depressed. Since the bulk of the evidence for harmful attention andmood effects from television and computer use is found in the developingbrain, a mature trader will have signiﬁcantly less problems with prolongedmarket watching than an infant or adolescent. Yet in my clinical practice,I have occasionally seen traders who were burned out by their constantvigilance to news feeds.
Information overload occurs when people are faced with too much in-formation to process. When overload occurs, most people prefer to with-draw and avoid making a decision until they better understand the situa-tion. If they cannot delay the decision, then they rely on how their feelings
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and memories. As a result, when too much information is present, peopleare more vulnerable to biases. Novice investors who have not prioritizedthe information they use in decision making are susceptible to overload.
REPRESENTATIVE RETURNS
While watching information ﬂow, many traders monitor the daily “mostactives” list. Many inexperienced investors view recent returns as repre-sentative of what they can expect for future performance.
The bias associated with overweighting recent events in one’s futureforecasts is called the representativeness heuristic, and it is related to the“hot-hand” bias mentioned in Chapter 18. Fundamentally, the representa-tiveness heuristic is a short-term memory bias in which simple, recent in-formation cues are overweighted in decision making.
Professors Dhar and Kumar investigated stocks bought by more than40,000 American households at a discount brokerage during a ﬁve-year pe-riod. On average, the stocks that investors bought had already increased by0.6 percent during the week before the purchase. When Dhar and Kumarexpanded their window of investigation, they found an increase of 1.2 per-cent, 2.2 percent, and 7.3 percent for the two-week, one-month, and three-month periods before the purchase, respectively. Individual investors werebuying stocks that had recently outperformed.1
Academics are also affected by the representativeness bias in theirstock market forecasts. Professor Ivo Welch elicited professors’ estimatesof the expected annual equity risk premium over the next 30 years via sur-veys. The equity risk premium is the annual percent return by which stocksare expected to outperform bonds. Recent market price trends strongly bi-ased their 30-year estimates.
The ﬁrst series of surveys were implemented during the bull marketof 1997–1999.2 Finance professors judged the expected annual equity riskpremium over the next 30 years at an average of 7.2 percent.
Welch again surveyed the professors during the bear market of 2001.3If professors had previously estimated returns according to mean rever-sion, then one might expect respondents to estimate a higher equity riskpremium after a market decline. In fact, in 2001 the average expectationfor the annual 30-year equity risk premium was 5.5 percent, about 1.7 per-cent lower than the bull market estimate. This pattern of high estimateswhen things are good and low estimates when they are bad is consistentwith the representativeness bias. That is, the professors derive their esti-mates not from an objective consideration of past decades, but rather fromrecent events in the markets.
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In Welch’s study of academics forecasting the equity premium, the sub-jects did not succumb to a “mean-reversion” bias. In Chapter 18, there isevidence that professionals and academics are more susceptible to mean-reversion biases in their forecasts, so there is an apparent contradiction.Perhaps academics exhibited representativeness because they were (1)not able to reference a historical price chart of the equity premium and(2) were making 30-year forecasts rather than annual predictions (as theywere in the example in Chapter 18).
Because of the strong inﬂuence of the representativeness heuristic ininvestor purchase decisions, securities authorities have ruled that the dis-claimer “past performance does not guarantee future returns” must be at-tached to all mutual fund advertising. In effect, government regulators arewarning investors away from biased decision making.
FOND MEMORIES
In general, people preferentially remember events that have a strong emo-tional association (either good or bad). As a result, they overweight thesigniﬁcance of these events when referencing the past to make forecastsabout the future. If an investor has a strongly negative or positive ex-perience in the markets, then that single experience is likely to be over-weighted when the investor is making future plans.
For people who lost all their savings in the stock markets of 1929 and1930, if they never reentered the markets, they would always think of thestock market as a very dangerous place to invest. Those who did musterthe courage to reenter would better remember their large gains in the 1940sand 1950s, since those memories would be more recent and overweightedversus one’s fading recall of the 1929 crash.
Using Professor Knutson’s monetary incentive delay (MID) task, inwhich scaled monetary rewards and losses are delivered to experimen-tal subjects during functional magnetic resonance imaging (fMRI) scan-ning, Stanford postgraduate researcher Alison Adcock tested the strengthof reward memory formation. Pictures of neutral scenes and objects thatfollowed a high-value reward cue (the possibility to earn $5) were moreclearly remembered three weeks after the experiment. When subjects re-called these pictures, the nucleus accumbens and the hippocampus (anexplicit memory region) were much more activated when viewing the im-ages that accompanied the high value reward cue. According to Adcockand Knutson, the ﬁndings are consistent with the hypothesis that rewardmotivation promotes memory formation via dopamine release in the hip-pocampus prior to learning.
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Interestingly, the researchers found individual differences in memoryencoding, where individuals who showed greater anticipatory reward sys-tem activation also demonstrated superior memory. The more excited oneis about a potential reward (nucleus accumbens activation), the more theyremember the context and environment where the reward cue occurred(hippocampal activation).4 Investors who see sexy models and fast sportscars in stock promotions are more likely to remember the name of thestock. When recalling the stock, they are more likely to feel positively aboutit, and thus more likely to take a chance and buy it.
Memories ensconced in the hippocampus appear to bias one’sthoughts about the future. It turns out that the hippocampus is accessedwhen people make forward-looking estimates or projections.5 That ﬁnd-ing may imply that people are unable to disregard their memories duringconsiderations of the future. In fact, they use their memories to constructpossible scenarios that are used in planning, which may explain (1) whyinvestors are susceptible to the representativeness (recency) bias, and (2)why investors tend to be miscalibrated (overconﬁdent) when estimating fu-ture outcomes. Professionals cannot escape the tyranny of their own mem-ories without practice and training. Financial markets have no memory,and investors stuck in past mental models will be less adaptable to chang-ing market conditions.
BEATING THE HINDSIGHT BIAS
One of the most pernicious memory biases is called the hindsight bias.The hindsight bias refers to the fact that most people think they “knewit all along.” After an event occurs, they think that they had predicted itwould happen in advance, when in fact they did not. The danger of thehindsight bias is that it prevents people from learning from their mistakes.Unless they documented their forecasts in advance, they have no objectiveevidence that they did not expect the event to happen.
Professor Paul Slovic found that the best mechanism for ﬁghting thehindsight bias was to encourage people to explicitly think about the “coun-terfactuals.” That is, after an event happened, experimental subjects wereencouraged to consider how other possible outcomes might have occurred.What conditions could have contributed to different results? Consideringsuch a question, subjects became less anchored to the actual outcome(which dominated their recollection), and became more open to other pos-sible lines of reasoning in advance of the event.
In experiments, Slovic found that the hindsight bias was still presentwhen this technique was followed, but it was much reduced.6 Slovic’s
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result supports the value of journaling. For example, while an investor mayclaim to have known that the U.S. dollar would peak in 2002, if they hadbeen recording their thoughts and observations in a journal, they couldconﬁrm their memories. They could reexamine the risks and opportunitiesthey had identiﬁed in macroeconomic and currency systems. Were theyas certain about the dollar’s decline as they remember being? Importantly,reviewing a journal can help one identify the risks that were overlookedand the opportunities that were discounted (which memory alone cannotrecall). Such a review of one’s thought process, being sure to identify coun-terfactual evidence, improves future reasoning.
The next two sections will move away from memory biases andaddress attention biases. Speciﬁcally, they discuss how people focus,what interrupts their concentration, and the neuroscience behind payingattention.
ATTENTION DEFICIT
The process of paying attention should be distinguished from arousal. Vigi-lance, wakefulness, arousal, and alertness are not types of attention. Focusand concentration are. Drinking 10 double-shot lattes will increase one’svigilance (and bladder tension), but will decrease one’s ability to concen-trate.
Some people are very good at maintaining focus, while others strugglewith constant distractibility. Some people are unable to function in a nor-mal workplace or relationships due to constant distractibility and inatten-tion. They may be suffering from attention deﬁcit–hyperactivity disorder(ADHD). ADHD is a well-studied illness with neural origins and medica-tion treatments (described in the following section).
Excellent concentration is often found among meditation masters.Meditators who exercise their “attention muscles” regularly during longsitting sessions have improved abilities to focus, attend, and concentrate.Many long-time meditators can demonstrate fascinating beneﬁts of such at-tentiveness, occasionally using mental concentration to self-regulate phys-iological processes (such as heart rate, blood pressure, and skin temper-ature). Furthermore, there is fMRI evidence that experienced meditatorscan inhibit limbic impulses, such as the startle response and fear, betterthan nonmeditators. There is evidence that meditators’ superior powers ofconcentration originate in the prefrontal cortex. Researchers have foundmuch greater prefrontal cortex electrical activations on electroencephalog-raphy in trained meditators. The prefrontal cortex is not the only brain re-gion involved in attention.
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The reward system will try to shift one’s focus toward anything newor unusual for further investigation. Neuroimaging research demonstratesthat the reward system is activated by novelty,7 and it is a driver of curios-ity and discovery. In order to maintain attention on one task, people needto inhibit the frequent novelty-seeking impulses arising from their rewardsystem.
The reward system’s novelty-seeking and attention-shifting urges areprioritized and managed by the prefrontal cortex. It considers the varioussignals from the reward system and then decides whether to continue withthe current task or to shift attention. Sometimes the prefrontal cortex isthinned, and it loses the strength to enforce discipline on the reward sys-tem. Chronic drug addicts, older adults (over 80 years old), and prisonershave all been found to have thinner prefrontal cortices than healthy middle-aged adults. These populations have difﬁculty maintaining focus on onetask for prolonged periods, and they all struggle to resist potentially re-warding temptations (drugs, investment scams, and crime, respectively).
Poor prefrontal cortex function, and the inattention that results, canbe managed with exercises (such as meditation or yoga) or medications.Researchers found that a regular yoga practice, in which the attention iscontinuously maintained on either a repeated mantra (phrase) or the sen-sation of breathing, can reduce the signs and symptoms of ADHD in chil-dren. The medications that are capable of managing ADHD can shed lighton the chemical origins of the disorder.
KEEP YOUR EYE ON THE PILLS
The medications that are most successful in improving attention in suf-ferers of ADHD are amphetamines and their chemical derivatives. Am-phetamines are stimulant medications that block the neuronal reuptakeof norepinephrine and dopamine, increasing their concentrations in thesynaptic cleft. In the 1950s and 1960s amphetamines were prescribed aspick-me-up pills, because for most people they provide alertness as well asattention. In the United States they are now under stricter government con-trol. Commerical medications used to treat ADHD include methylphenidate(Ritalin), Adderall, Concerta, and others.
Neuroimaging researchers have found that ADHD sufferers have de-creased activation in the anterior cingulate cortex (ACC) versus normals.This difference may represent a lack of conﬂict resolution in ADHD brains,where incoming stimuli are usually prioritized through ACC processing.8Anatomically, the ACC is a region of the prefrontal cortex.
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Professor Knutson administered intravenous amphetamines to sub-jects before they played his monetary incentive delay (MID) task in a fMRIscanner. Subjects who received amphetamines had decreased peak activitybut longer time of activation in the nucleus accumbens (NAcc) when antic-ipating ﬁnancial gains. This activation pattern may be a result of improvedmodulation of attention—decreased sudden reactivity to any particular re-ward stimulus.9
Knutson also discovered that children with ADHD have decreased ac-tivation of the reward system, and speciﬁcally the NAcc, when anticipatingrewards.10 This hypoactivation may represent the neural basis of difﬁcultymaintaining goal orientation, impaired memory and learning, and suscepti-bility to depression among ADHD patients.
Consider Collin’s story, which opened this chapter. For day traders, ifintense market monitoring desensitizes dopamine circuits, then this mayexplain Collin’s gradual decline in relationship skills and pleasure. Dur-ing the trading day he learned to take his prefrontal cortex off-line so hecould quickly ﬁnd and attend to potential trades. Every potential oppor-tunity caused a surge of dopamine. Eventually, the downstream neuronswould downregulate their dopamine receptors after several days of contin-ual stimulation. Such desensitization can be recovered by training. Collin’ssilent one-month mindfulness retreat may have reequilibrated his rewardsystem and reinforced his use of the prefrontal cortex.
WHAT’S IN A NAME?
While the stock exchange’s “most actives” list is one way that stocks arebrought to investors’ attention, their names can also be a useful marketing“hook.” Studies have shown that investors more often put their money inequities with catchy (easily remembered) or seductive (exciting) names. Atthe core of this naming bias is the usual neural culprit—the reward system.funds over the period1994–2001, name changes associated with currently “hot” investment stylesprompted increased net fund inﬂows of 27 percent for the year followingthe name change. This effect occurred regardless of whether the namechange was only symbolic and without any underlying change in invest-ment style or strategy.
Researchers found that
for 296 mutual
On average, investors who moved into renamed mutual funds lostmoney. According to the study authors, it appeared that the name changeswere timed to trick investors into expecting better future performance thanwas actually delivered.11
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Companies can change their stock tickers to be more compelling, suchas Harley Davidson changing from HDI to HOG. Interestingly, such symbol-changing stocks have increased returns, versus the overall market, fol-lowing the change. Examples of evocative stock symbols include LUV forSouthwest Airlines, Sotheby’s (BID), and Advanced Medical Optics (EYE).From 1984 through 2004, stocks with clever symbols appreciated 23.6 per-cent compounded annually, compared with 12.3 percent for all stocks onthe New York Stock Exchange and NASDAQ.12 According to researchers,“One possible explanation for the results is that people prefer to work withinformation they can easily process.”13
Further evidence for the “irrational” value of names came from a studyby Princeton psychologists. They found that a basket of companies withpronounceable stock symbols gained 11.2 percent more in the ﬁrst day oftrading after their initial public offerings (IPOs) than other stocks.14 “Theseresults imply that simple, cognitive approaches to modeling human behav-ior sometimes outperform more typical, complex alternatives.”15 Catchystock symbols and pronounceable names are more mentally accessibleas investment decisions are formulated. They provide an easy process-ing shortcut, are often titillating (rewarding), and are thus more attention-getting and easily available for recall.16
It’s not only mutual fund names and clever stock symbols that drawinvestors. Concepts such as new economy reﬂected perceptions of a fun-damental transformation in business, suggesting that the old risks of in-vesting no longer applied. Internet and technology stock investors wereoften seduced by the novelty and limitless potential of the “new economy.”At the turn of the millennium, newly opening export markets, such asthose of the former Soviet Block, China, and India, provided billions of newconsumers to whom American companies could peddle their wares. Oneof these opening markets—China—and a world-changing technology—theInternet—provided the context for one of the most overhyped stocks inhistory, solely based on its name.
CHINA PROSPERITY INTERNET HOLDINGS
As foreign ﬁrms set up shop in China in the 1990’s, considerable euphoriaaccompanied their efforts. China was portrayed as an untapped market of1.3 billion consumers, ripe for the ﬁrst movers. Stock investors were keento ﬁnd companies that were well-positioned in this market. The stock ofone company, China Prosperity Internet Holdings, experienced an investorfrenzy in late 1999 based solely on the expectations attached to the com-pany’s name.
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In November 1999, I was surﬁng stock message boards where Chinesestocks were discussed. At that time I was using stock trading strategies ofmy own design, based on the psychology of stock message board conver-sations. On the morning of November 16, 1999, I noticed a message abouta stock called China Prosperity Internet Holdings (CPIH) on one of theboards I was following.
A message board poster claimed that CPIH was going to be the nextbig thing. “Catchy name,” I thought, and I decided to check it out. Oddly, Ithought, I couldn’t ﬁnd any substantive information on the company funda-mentals through an Internet search, Yahoo! Finance, the SEC, or the Bul-letin Board Stock Exchange web site.
I looked at the stock price chart. Over the past three months, fewshares of the stock had traded at all, and it had remained priced at $0.25.So far that day, November 16, 1999, the stock had jumped from $0.25 to$1.00. Five hours remained in the trading day. The stock rose rapidly as Iwatched, and by the market close CPIH was over $14 per share. The nextday, the stock continued its ascent. It opened around $20 and then wasmentioned on CNBC. Within an hour it had hit $82, the day’s high. It closedthat day, November 17, 1999, at $32 per share. In the following days, theprice gradually declined. Trading dried up in early 2000, and the stock wassubsequently delisted.
Investors who dug deep enough could have found news regardingCPIH. It turned out that the directors of CPIH were under indictment forfraud by the Hong Kong securities authorities. Apparently, they had liedabout a merger between their company and a Bermuda-based company.Somehow, they managed to get a U.S. market listing on the bulletin boardexchange in the spring of 1999, prior to the announcement of their in-dictment. So it appeared that this company was simply an apparition—afraud—whose price had been drifting along sideways pending an indict-ment.
If CPIH wasn’t a real company, how could it rise 32,000 percent in twodays and be mentioned on CNBC? There was no positive information aboutthe company except its name, and anonymous tips on message boardsdidn’t initially tout the stock, but rather suggested “check it out.”
Because there was no other information besides a price chart and bul-letin board speculation, much of CPIH’s move was probably due to itsname. Day traders loved the idea of stocks with enormous potential mar-kets, in this case “China” and the Internet. On a more subtle level, investorsusually want some conﬁdence in their stock purchases. “Prosperity” is areassuring word. “Holdings” implied that the company wasn’t some one-hit wonder, and that it may have a complex corporate structure (hencethe lack of concrete ﬁnancials) and perhaps (considered by an excitement-stoked imagination) sizable assets or mutiple revenue streams. All-in-all,
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CPIH had an essentially perfect name for elevating expectations and in-ducing a short-term investor buying frenzy.
CPIH’s ascent to $14 was due to the viral spread of message board en-dorsements. On the second day of trading, CPIH got an extra boost afterbeing mentioned on CNBC. Even without substantive fundamental infor-mation, investors bought CPIH simply because they had heard about it, itsname was evocative, and its price was rising. With so many sources avail-able to research, and so little time to peruse, how do investors ﬁnd qualitystocks to buy?
“ALL THAT GLITTERS”
Individual investors often research those stocks that catch their attention.Yet attention is a limited resource. Since many investors observe the samesources of ﬁnancial information (such as CNBC or Bloomberg), there areoften herds of buyers chasing the latest stocks in the news. Stocks in thenews, such as those mentioned by Maria Bartiromo on the Midday Callon CNBC, experience almost ﬁve-fold increases in volume in the minutesfollowing the mention.17 It’s not only Bartiromo’s show that stokes investorbuying.
Finance professor Terrance Odean found that, over a large sampleof brokerage accounts, individual investors are net buyers of attention-grabbing stocks (e.g., stocks in the news, stocks experiencing high abnor-mal trading volume, and stocks with extreme one-day returns). Odean an-alyzed data at two brokerage ﬁrms and discovered that stocks bought byindividual investors on “high-attention days” (when they are in the news)tended to subsequently underperform stocks sold by those investors. Alarger proportion of investors buy individual stocks after news announce-ments than at other times. “When calculated by number for the large dis-count brokerage, buy-sell imbalance is 2.70 percent for stocks out of thenews and 9.35 percent for those stocks in the news. At the large retail bro-kerage, buy-sell imbalance is −1.84 percent for stocks out of the news and16.17 percent for those in the news.”18
No matter what the news, investors tend to buy stocks that are inthe public eye. Individual investors buy following many attention-gettingevents: high volume days, extremely negative and extremely positive one-day returns, news releases. Investors even buy following earnings sur-prises, regardless of whether they are negative or positive.19
While amateurs often fall into the attention-based buying trap, thesame cannot be said for professional investors. Odean found that insti-tutional investors (especially value-strategy investors—presumably more
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savvy than individual investors) did not exhibit attention-based buying.Other researchers have observed professional investors taking advantageof amateurs who chase big winners.
Professor Mark Seasholes and colleagues demonstrated that, on theShanghai Stock Exchange, individual investors are net buyers the day af-ter a stock hits an upper price limit. A larger percentage of purchases ismade by ﬁrst-time buyers on these days than on other days. The effect ofindividual investor buying is transitory, with reversion to prelimit-day lev-els within 10 trading days. According to Seasholes, a small group of profes-sional investors proﬁt at the expense of individual investors by anticipatingthis temporary bump in share price and demand.20
On the New York Stock Exchange, researchers found a similar patternto that in China.21 The next day gap up, following a large one-day gain,is often called “overreaction.” The morning gap up is called “overreaction”because the price tends to decline from the open throughout the remainderof the trading day. This overreaction pattern has been found to be strongerfollowing bad news (negative open with daytime rally) than good.22 Otherresearchers have found this pattern in Tokyo for the most actively tradedstocks.23 It appears that investors buy into the price momentum in a frenzyand then sell out the next day after the price momentum stalls.
Is there money to be made by fading (trading against) other investors’attention-based enthusiasm? Professor Seasholes discovered such a short-term trading strategy. Using a dataset of over 21 million matched transac-tions on the Shanghai Stock Exchange, Seasholes found that traders whobuy nearly limit-up stocks at the market close and sell them at the nextday’s open make an average of 1.16 percent per day per trade (on the open-ing gap).24 Seasholes speculates that the opening gap may occur due to theinﬂuence of evening Chinese television business news programs. Individ-ual investors who watch those programs then herd into the top performingstocks in the morning.
Traders pay attention to the market’s big movers. When amateur in-vestors buy or sell the “most actives” or large price movers, they are chas-ing those stocks (buying after a run-up or selling during a downturn). Un-fortunately, such a momentum strategy is unproﬁtable. Only professionalswho have learned how to manage momentum-driven enthusiasm can proﬁtfrom such an attention-based strategy.
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C H A P T E R 20
Age, Sex,and CultureRisk Taking around the World
Jim is an entrepreneurial ﬁnancial planner I met at a seminar. He oc-
casionally felt frustrated with his clients, and he wanted to discusssome of his client difﬁculties with me. In particular, he had been ﬂum-moxed by recent events with a client named Sharon. Sharon fell into re-sponsibility of a large sum of money through her husband, Tom, who hadrecently and suddenly died. Tom had worked for International Paper (IP),and he had a sizable amount of IP stock in their retirement fund. In fact,