Iconoclast: A Neuroscientist Reveals How to Think Differently (17 page)

Formulated in the 1960s by Eugene Fama, an economist at the University of Chicago, the EMH says that financial markets are informationally efficient. This means that the price of any asset represents the collective wisdom and knowledge of all the people trading in the market. As a direct result, the EMH says that it is impossible to consistently outperform the market. You may do so transiently by luck, but not for long. The flip-flopping of mutual fund rankings is broadly consistent with the efficient market hypothesis. But even here, a slight discrepancy remains. A very small group of funds and fund managers do tend to do better than others on a consistent basis.

Bill Miller, the manager of the Legg Mason Value Trust, with $20 billion in assets, beat the S&P 500 fifteen years in a row, a streak that finally came to an end in 2006. By that statistic alone, Miller qualifies as either the luckiest of all fund managers or the most iconoclastic. Believers in the EMH say that Miller was the beneficiary of a lucky streak, and in the grand scheme of the market, he will eventually be subsumed by the law of averages. A less literal interpretation of the EMH allows for the broad efficiency of the market, but certain assumptions make it possible to exploit advantages.

Like Dreman, Miller has always adhered to the value approach to investing. He, too, points to Benjamin Graham as an early influence. But Miller goes beyond the P/E ratio. While the P/E ratio is derived from the current price and most recent earnings, Miller says that the more important metric is future earnings. This is where Miller goes beyond Graham. “The only reasonable way to compare [companies] is between the returns you expect to earn from them.” To do that, you have to look to the future, not the past. It is for precisely this reason that Miller was heavily invested in Google, which, even at the time he bought it, had a P/E ratio of 50. To Miller, the distinction between value and growth investing is arbitrary. “Growth is an input to the calculation of value.”
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Unlike Dreman, however, Miller does not believe in the utility of simple-minded stock screening based on P/E ratios and the like. He doesn’t believe they say much about value. Such a screener would pass over Google because it appears overpriced according to past earnings. But many high-P/E stocks are a bargain when viewed from the perspective of
future
earnings. Again, like all iconoclasts, Miller is often able to maintain a different perception of value. While much of the market focuses on past earnings, he focuses on future earnings.

The problem, however, is that calculating future earnings is more art than science, something akin to looking into a crystal ball of the future. In contrast, P/E ratios are computed from known quantities and events that have already happened, and consequently there is no uncertainty
about the actual P/E figure. P/E ratios are comforting. Computing a valuation based on the future involves quite a lot more due diligence into what a company is planning and a bit of prognostication as well. But the real issue with estimating future value, as Miller does, is the uncertainty inherent to the process. The future will always be unknowable to a degree, and it is the fear of this uncertainty that prevents many, if not most, investors from using this method. Like the other iconoclasts, Miller does not let the fear of the unknown cloud his perception of value.

The Biology of the Fear of Failure

If fear of the unknown prevents most people from taking chances, you can sure bet the fear of failure does too. Any activity in which there is a possibility of failure is, by definition, risky, and it is this fear of failure that makes so many people risk averse. Like the fear of uncertainty and the fear of public ridicule, the fear of failure wends it way through the brain, distorting perception and inhibiting action. Thanks to several recent experiments, we are now beginning to figure out how this happens.

Although no experiment has directly examined the question of what is inside an iconoclast’s brain, there are studies that have identified neural links between brain differences and behaviors such as risk taking and fear avoidance. The ability to deal with bad news and maintain one’s perception, as we have seen, is a key attribute of the successful iconoclast. Dreman did not change his perception of stock valuation during the Internet bubble. And although he suffered through the loss of clients, he didn’t panic. Similarly, Miller did not change his perception of value according to commonsense, if simplistic, judgments based on P/E ratios. It seems obvious that there should be something different in the brains of people like Dreman and Miller, but because these individuals are rare, it is difficult to pin down what these differences might be. In 2005, my research group found one such difference in the brains of
people who reacted strongly to potentially negative information, which has direct implications for the iconoclastic brain.

While many of the early researchers in neuroeconomics focused on the brain’s response to financial incentives, my group turned to the equally important dark side of decision making: loss. And where loss looms, fear follows. Every decision that a person makes involves a weighing of upsides and downsides. Some people focus entirely on the possibility of a good outcome, while others fixate on the negative. Sound decision making walks a fine line between these two extremes. From a scientific point of view, it has been surprisingly difficult to study the fear of loss on decision making. Nobody will volunteer for an experiment in which they could lose money. Moreover, ethical rules governing human experimentation prohibit experiments in which volunteers have to pay to participate.

For these reasons, we designed an experiment to examine the effect of a potentially painful outcome on decision making. Understanding how the brain processes pain is of great medical importance, but pain is also crucial to deciphering the iconoclastic brain. Iconoclasts go against the herd. So like Martin Luther King Jr. and others, they inevitably will suffer at some point from fear and the pain of social isolation, if not outright hostility. For most people, the fear of pain or loss is enough to deter them from action.

The experiment went like this.
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The volunteer was told that the experiment was designed to understand how the brain processes pain. But there was more to it than that. In actuality, we were really interested in the brain’s response to the anticipation of pain. Because unpleasant and potentially painful outcomes in life are unavoidable, how people deal with the anticipation is critical for understanding the decision-making process that distinguishes successful iconoclasts from those who simply give in to their fears. We used the prospect of physical pain in this experiment because it is scientifically expedient to deliver and controllable. The subject was shown an electrical stimulating
device that is commonly used in studies of nerve function. In our experiment, however, the electrodes were attached to the top of the subject’s left foot. Through these electrodes, we sent very brief electrical shocks. Although not unbearably painful, the shocks were designed to be unpleasant enough that the individual would prefer to avoid them altogether. The kicker was that they had to wait for the shocks. Every trial began with a statement of how big a shock they were going to receive and how long they had to wait for it, which ranged from one second to almost thirty seconds. For many people, the waiting was worse than the shock. How bad was it? Given a choice, almost every individual preferred to expedite the shock and not wait for it. Nearly a third of the people feared waiting so much that when given the chance, they preferred to receive a bigger shock sooner rather than waiting for a smaller shock later. This was exactly the type of impulsive behavior that we were interested in and that gets in the way of sound financial decision making. We dubbed them “extreme dreaders.”

When we examined the brain responses of the different individuals, we found a neural fingerprint that differentiated the cool cucumbers from the extreme dreaders. A part of the brain associated with processing physical stimuli, called the
secondary somatosensory cortex
, had a rise in activity in the extreme dreaders when they were shown the information about how long they would have to wait. The brains of their more patient counterparts did not show this early response. Instead, their brains reacted with a gradual rise in activity up to the point of the shock. We found similar differences in other parts of the cortical pain network, including the
anterior cingulate cortex
, which lies in the midline of the brain and straddles the bundle of fibers connecting the left and right hemispheres, and is frequently activated during stressful events. Considering these findings from the other direction of causality, you could say that hyperactivity in this network of brain regions might actually be the cause of impulsive, irrational behavior, at least when it comes to the fear of something unpleasant.

How Fear Clouds Financial Judgment

Identifying differences in brain activation in the laboratory is one thing, but demonstrating that these differences have any practical application in the real world is an entirely different matter. Andrew Lo, a professor of finance at the MIT Sloan School of Management, has been examining the link between biology and financial decision making. Lo’s work is at the cutting edge of neuroeconomics and represents some of the most intriguing directions in which both neuroscience and biological information are being applied in the business world. Lo believes in the general principle of the efficient market, but because some individuals seem to do better than others, he has explored the possibility that biological differences underlie the performance inequities between winners and losers seen in any market. Although markets might be broadly efficient, Lo’s work suggests that differences between individuals in the market create small, but transiently leverageable opportunities for profit. The key lies in the emotional brain, especially fear circuits.

In 2001, Lo teamed up with a young Russian physicist/cognitive neuroscientist, Dmitry Repin, to measure physiological responses in professional traders.
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Lo and Repin recruited a small group of traders who worked in the foreign-exchange and interest-rate derivatives unit of a major global financial institution based in Boston. On a typical day, this unit engaged in 1,000–1,200 trades and averaged $3 million to $5 million per trade. Lo and Repin wired up ten traders to measure a range of physiological responses that included blood pressure, body temperature, respiration rate, skin conductance responses (sweating), and measurements of muscle contractions in the face and arm. These measurements were collected for a period ranging from forty-nine to eighty-three minutes during live trading hours. After the session, Lo and Repin examined the correlation between these physiological parameters and specific volatility events in the market. Lo and Repin used a computer
algorithm to extract these events in markets that traded foreign currencies, including the euro, the Japanese yen, and the British pound. The volatility events included price deviations, spread deviations, price-trend reversals, and both price and return volatility. Lo and Repin also divided the traders into inexperienced and seasoned categories to see whether experience affects an individual’s autonomic reactions to market events.

Although this was a small sample of subjects, Lo and Repin found surprising correlations between physiological responses and market trends. The most strongly correlated parameter, blood pressure, rose in both novice and experienced traders when an asset’s maximum volatility went up. Volatility was measured as the difference between the maximum and minimum price over a short time interval and calculated as a fraction of the average price. It was related to the short-term variance of the asset. In a more detailed analysis, they found that this rise in blood pressure occurred well in advance of the key volatility event. This suggested that the traders’ bodies responded to cues in the market that preceded the large-scale event that subsequently showed up as a price change. This observation raises the intriguing possibility that the brain (and the body) picks up subtle cues in the market that are not apparent from trend analyses.

As exciting as these findings were, Lo and Repin were not able to prove a causal link between physiological reactions and individual performance in the market. In a later experiment on eighty day traders who were participating in an online training program, they did find the first hint of a link between emotional reactivity and performance.
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Although they were unable to use physiological measurements, Lo’s team examined the link between trading results and emotional state. They also wanted to know whether a specific personality was particularly good at trading. Using standard personality inventories, Lo found no correlation between personality and trading performance. From this, he concluded
that there was no ideal “stock market personality.” In contrast, Lo did find correlations of positive and negative mood states with daily performance, which, by itself, is really not very surprising. People are happy when they make money, and unhappy when they lose it. The key finding was that these correlations were the
strongest for the worst traders
. The worst traders let their emotions color their perception of valuation and cloud their decision making.

Henry Ford and the Freedom from Fear

Henry Ford was an iconoclast on so many levels, ranging from his views on capitalism and world peace to his development of the assembly line, but he had clearly articulated views about the damaging effects of fear in business and how to deal with it. Born in 1863 on a farm in Dearborn, Michigan, Ford recalls that he grew up witnessing too much hard labor on the farm. He started building steam engines first, with the goal in mind of alleviating the sweat-and-blood drudgery of farm work. And then he read of the gas engine. Built in England, these early engines couldn’t develop anything near the power of a steam engine, and Ford’s interest was more out of engineering curiosity than anything else. These single-cylinder jobs were hugely inefficient, requiring four cycles to develop one power stroke. And it wasn’t until 1890 that Ford took a serious interest in double-cylinder engines.