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moneysense.ca, 21/10/07
Pigeons, Rats, and Investors
I am currently reading Your Money & Your Brain, a fascinating new book on behavioural finance by Jason Zweig. The book shows how our brains, which evolved to help us survive as a species, lead us completely astray when it comes to investing. The chapter on how humans tend to see patterns even when there are none describes a fascinating experiment involving birds, rodents and people, a version of which is available here.
When researchers flash a red light and a green light on a screen in a random fashion but with the green light flashing 80% of the time, pigeons follow the simple strategy of guessing green all the time to earn the most rewards. People, however, attempt to guess the next flash accurately even after they were told by researchers that the sequence is random. This misguided strategy means that people pick the next flash accurately only 68% of the time.
Now we know why we try to figure out where the market is going next: we just can’t help it.
moneysense.ca, 21/10/07
Actually our brains evolved to help us survive as individuals (the species survives as a byproduct of individual survival…natural selection operates mostly at the individual level…or the gene level if you buy Richard Dawkins’s theory). Individual survival also explains another human trait that often runs counter to wise investing and saving habits: short-term rewards are more attractive than long-term rewards that involve short-term sacrifice. Saving for the future is actually contrary to human nature: we’re hard-wired for instant gratification, because our ancestors who sacrificed often didn’t live long enough to reap the rewards, and thus didn’t pass on that trait to their surviving offspring. Saving and investing for the future are features of our cultural evolution, which attempts to transcend our baser human instincts.
What? Where did you get that stuff about human nature from? Even back when we were in hunter-gatherer societies, humans would have had to save up provisions to survive the trip until they reach the next hunting grounds. And when we moved to an agrarian society, it became all about storing grain to make it through the winter months between harvest seasons. I would dispute the fact that we are hard-wired for instant gratification – it sounds to me like a lot of brainwashing from the baby boomers to try to make themselves sound like victims of their genetics why they didn’t save for retirement. And I know quite a few boomers in that category.
But with that being said, I will have to admit it can be interpreted that the reason why I max out my RSP every year is for the “instant gratification” of having some tax relief. And when I invest outside of my RSP, I invest for the purposes of supplementing my earned income, not necessarily saving for the future.
Phil, the behavior you’re describing (storing provisions, etc.) is learned behavior, not inherited; it’s cultural knowledge passed on from generation to generation. That’s not what I mean by hard-wired. There’s a lot of evidence that humans have a hard time overcoming our tendency to value short-term self-interest over long-term interests (self-interest or public interest), but fortunately we can sometimes transcend those tendencies through cultural pressure, education, or simple logic.
Hmm, red and green lights, eh.. Sounds like a great idea for some late night infomercial trading platform.
How could people underperform if this is truly random ?
Anyhow, assuming a 50-50% game where this result would be replicated (pattern driven people guessing under 50 %), would it imply that betting against the people would lead to a positive expectation game?
I can think of a few casino games application…
Comments ?
Robert: People under perform because they try to guess the next flash despite being told that the sequence is random. Jason Zweig cites research to suggest that we are wired that way. He calls it “prediction addiction”.
Prediction addiction sounds good marketing-wise for a book but is meaningless to explain the underperformance.
In random games, there is no reason for people to underperfom whether they try to guess or not since the outcome is not dependent of them guessing (or not). The expectation of the game remains the same.
The argument could be made (successfully) for games where the behaviors of the participant influence the outcome of the game (stock market, poker, etc.). The mathematical expectation can be modified by superior or inferior tactics. Studies support that in fact in financial endeavors; even more so when bankroll variables are factored-in.
Do I make any sense? If so, my first question remain…
Surely the results depend on people’s guesses. If the sequence is GGRGG and I guess GGGGG, I get 80% right. If on the other hand, I guessed GGGRR, I only got 60% right.