Blame Your Limbic System
The human limbic system controls emotions, behaviors, and long-term memory (among other functions). The amygdala is the part of the limbic system that processes emotions. Small, almond-shaped, and deep inside your brain, it also links emotions to memories, learning, and your senses.
When a threat is detected, it directs your hypothalamus to produce hormones, including cortisol and adrenaline. You are more familiar with it by its informal name: fight or flight.
This is enormously important to investors. “To the extent you succeed in finance, you succeed by suppressing the limbic system, your system 1, the very fast-moving emotional system. If you cannot suppress that, you are going to die poor.”304
So says Dr. William J. Bernstein, PhD, MD, a retired neurologist, principal in the money management firm Efficient Frontier Advisors, and author of several bestselling books on finance.305
In The Delusions of Crowds, he explains why the human brain’s evolutionary development leads us astray in modern capital markets.306 In his view, “Humans are the Apes that tell stories, imitate others, and seek status.” This combination ultimately leads to group dynamics where entire populations become deeply entrenched in a belief system that, before revealed as false, runs amuck.
Nowhere in the modern world do we see the effects of our emotional behavior more clearly than in markets. Our emotions lead us to be overconfident when we should be humble, panicked when we should be circumspect, and deeply engaged in seeking information that confirms (rather than disconfirms) our preexisting beliefs.
The consequences range from witch burnings to financial ruin. In the modern era, this tribal behavior can lead to belief in false narratives, the rise of meme stocks, and, eventually, bubbles and market crashes.
Why is this so?
According to Bernstein, humans are “cognitive misers,” relying on simple narratives instead of using complex analytical thinking. The more compelling a narrative is, the more corrosive it becomes to our analytical abilities. The two most compelling tales are the Apocalyptic “End of Days” stories and the “effortless riches” meme. These are rife in both social media and religious narratives because they are such effective emotional triggers. They create frequent and substantial crowd delusions.
From an evolutionary perspective, there is little cost to our patternization—seeing patterns where none exist (amateur chartists are notorious for this). Jumping out of the way at the sight of a vine that looks like a venomous snake is a false positive that is mildly embarrassing at worst. But false negatives—ignoring the vine that is actually a deadly viper—carries the ultimate evolutionary cost. Perhaps this explains why we pay so much attention to bad news while ignoring positive developments.
Existential threats matter deeply to our limbic systems. Investors need to understand why these same evolutionary traits—the ones that helped us survive and adapt on the savanna—can lead to expensive errors today.
This evolutionary baggage we all carry—why does it still have so much sway in the modern world? Haven’t we evolved past this?
Put simply, we just ain’t built for it.
The best explanation why comes from Michael J. Mauboussin, adjunct professor of finance at Columbia Business School, and head of consilient research at Morgan Stanley’s Counterpoint Global. He explains why we aren’t hardwired to undertake risk and reward analysis in modern capital markets: “The mind is better suited for ‘hunting and gathering’ than it is for understanding Bayesian analysis.”307
Mauboussin reaches a similar conclusion to Bernstein: Most people lack the emotional detachment and discipline required for good, long-term performance in the markets.
The primate species we know as Homo sapiens has been around for about two million years. Modern finance has been around for a handful of decades. If all of human existence was a 24-hour clock, then investing as we understand it today has been around for merely 2 seconds.
Mauboussin asks the human species this question: “What have you learned in the past 2 seconds?”308
The answer, unfortunately, is “Not enough...”
Been round here long?
Up next, we look at how and why we panic at exactly the right time to stay alive, but precisely the wrong time to be good investors.
304 Barry Ritholtz, “Transcript: William J. Bernstein,” The Big Picture (March 7, 2021).
305 Efficient Frontier Advisors, www.efficientfrontier.com
306 William J. Bernstein, The Delusions Of Crowds: Why People Go Mad in Groups (Atlantic Monthly Press, 2021).
307 When you see the term “Bayesian,” think of it as meaning “Probabilities;” for any given theory, what probability best expresses the degree of belief you have that the hypothesis is true?
308 Michael Mauboussin, “What Have You Learned in the Past 2 Seconds?” Frontiers of Finance, Credit Suisse, First Boston (March 12, 1997).