Your Money & Your Brain

June 12, 2008

 

[The following is an excerpt from Jason Zweig's recent book, Your Money & Your Brain: How the New Science of Neuroeconomics Can Help Make You Rich, Simon & Schuster, August 1, 2007.]

Pecuniary motives either do not act at all—or are of that class of stimulants which act only as Narcotics. —Samuel Taylor Coleridge

 

From Babel To Bubble

In the Mesopotamian galleries of the British Museum in London sits one of the most startling relics of the ancient world: a life-size clay model of a sheep's liver, which served as a training tool for a specialized Babylonian priest known as a baru, who made predictions about the future by studying the guts of a freshly slaughtered sheep. The model is a catalog of the blemishes, colors, and differences in size or shape that a real sheep's liver might display. The baru and his followers believed that each of these variables could help foretell what was about to happen, so the clay model is painstakingly subdivided into sixty-three areas, each marked with cuneiform writing and other symbols describing its predictive powers.

What makes this artifact so astounding is that it is as contemporary as today's coverage of the financial news. More than 3,700 years after this clay model was first baked in Mesopotamia, the liver-reading Babylonian barus are still with us—except now they are called market strategists, financial analysts, and investment experts. The latest unemployment report is ''a clear sign'' that interest rates will rise. This month's news about inflation means it's ''a sure thing'' that the stock market will go down. This new product or that new boss is ''a good omen'' for a company's stock.

Just like an ancient baru massaging the meanings out of a bloody liver, today's market forecasters sometimes get the future right—if only by luck alone. But when the ''experts'' are wrong, as they are about as often as a flipped coin comes up tails, their forecasts read like a roster of folly:

  • Every December, BusinessWeek surveys Wall Street's leading strategies, asking where stocks are headed in the year to come. Over the past decade, the consensus of these ''expert'' forecasts has been off by an average of 16 percent.
  • On Friday the 13th in August 1982, the Wall Street Journal and the New York Times quoted one analyst and trader after another, all spewing gloom and doom: ''A selling climax will be required to end the bear market,'' ''investors are on the horns of a dilemma,'' the market is gripped by ''outright capitulation and panic selling.'' That very day, the greatest bull market in a generation began—and most ''experts'' remained stubbornly bearish until the rebound was long under way.
  • On April 14, 2000, the NASDAQ stock market fell 9.7 percent to close at 3321.29. ''This is the greatest opportunity for individual investors in a long time,'' declared Robert Froelich of Kemper Funds, while Thomas Galvin of Donaldson, Lufkin & Jenrette insisted ''there's only 200 or 300 points of downside for the NASDAQ and 2000 on the upside.'' It turned out there were no points on the upside and more than 2,200 on the downside, as NASDAQ shriveled all the way to 1114.11 in October 2002.
  • In January 1980, with gold at a record $850 per ounce, U.S. Treasury Secretary G. William Miller declared: ''At the moment, it doesn't seem an appropriate time to sell our gold.'' The next day, the price of gold fell 17 percent. Over the coming five years gold lost two-thirds of its value.
  • Even the Wall Street analysts who carefully study a handful of stocks might as well be playing ''eeny meeny miny moe.'' According to money manager David Dreman, over the past thirty years, the analysts' estimate of what companies would earn in the next quarter has been wrong by an average of 41 percent. Imagine that the TV weatherman said it would be 60 degrees yesterday, and it turned out to be 35 degrees instead—also a 41 percent error (on the Fahrenheit scale). Now imagine that's about as accurate as he ever gets. Would you keep listening to his forecasts?

All these predictions fall prey to the same two problems: First, they assume that whatever has been happening is the only thing that could have happened. Second, they rely too heavily on the short-term past to forecast the long-term future, a mistake that the investment sage Peter Bernstein calls ''postcasting.'' In short, the ''experts'' couldn't hit the broad side of a barn with a shotgun—even if they stood inside the barn.

As a matter of fact, whichever economic variable you look at—interest rates, inflation, economic growth, oil prices, unemployment, the Federal budget deficit, the value of the U.S. dollar or other currencies—you can be sure of three things: First, someone gets paid lots of money to make predictions about it. Second, he will not tell you, and may not even know, how accurate his forecasts have been over time. Third, if you invest on the basis of those forecasts, you are likely to be sorry, since they are no better a guide to the future than the mutterings of a Babylonian baru.

The futility of financial prediction is especially frustrating because it seems so clear that analysis should work. After all, we all know that studying beforehand is a good way to improve our (or our children's) test scores. And the more you practice your golf or basketball or tennis shot, the better player you will become. Why should investing be any different? There are three main reasons why investors who do the most homework do not necessarily earn the highest grades:

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