Saturday, July 21, 2012

When Investing, Our Short Term "Wiring" is a Long Term Problem ... It's the "Frontopolar Cortex," Stupid!

Short-term-itis is a very real aspect of our human nature. Simply put, we tend to value NOW especially when compared to any future time. Our present self rules our future self, in other words. Why do today that which can be put off until tomorrow goes the thinking. Or if you prefer, it's the if it feels good, do it way of behaving. Ice cream, anyone? Or shall we start that diet right now?

Economists label this "present versus future self" dispute as time inconsistency or dynamic inconsistency. Now we know we're wired that way.

As decision makers we have several different "selves." All too often an especially high value is placed on what today's self values. Our future self isn't given much attention.

This bird in the hand phenomenon is true in politics, personal habits and virtually all situations. It's simply part of our human condition. Of course, not everything that is part of our human condition is good for us, and that's particularly the case with short-term-itis and its effects on investing.

So now let's focus on investing and in particular do-it-yourself buy-and-hold low cost boring investing. That's my style and I recommend that you consider it as well. I even have scientific evidence to offer, even though this is the first time I've learned that I have a "frontopolar cortex." Evidently it's what makes us humans smarter than other animals. That said, it also makes us vulnerable to short-term-itis and its ill effects. So here we go, sports fans.

Why We're Driven to Trade has the short-term-itis and short term trader versus long term investor mentality story:

"With computerized traders that "hold" stocks for only a few seconds at a time and markets that can swing wildly in a matter of moments, long-term investing seems to be on the verge of extinction.

Perhaps this is inevitable. It turns out that short-term thinking is deeply embedded in the workings of the human brain. New research suggests that in order to avoid trading your accounts to death, you must counteract some of the very tendencies that make Homo sapiens the most intelligent of all species. . . .

Directly behind your forehead is a region of the brain known as the frontopolar cortex. Much larger in humans than in other primates, this area is critical to such advanced mental functions as memory, exploring new environments and making decisions about the future.

In (a) new study, the researchers wanted to see how the frontopolar cortex contributes to predicting rewards. So they compared people with damage to the frontopolar cortex against two control groups of healthy people and those with injuries elsewhere in the brain (but not the frontopolar cortex).

All the participants played a game in which they sampled four slot machines. They were free to play whichever machine they thought would give the biggest payoff. What they didn't know was that the payoffs from each machine varied unpredictably.

The neuroscientists found that the two control groups tended to make their next bet based largely on how much a slot machine had paid off on the two most recent bets.

Almost as soon as the pattern of payoffs appeared to change, the participants in the control groups dumped one slot machine and jumped to the next. Although they did take longer-term results partly into account, "the healthy subjects appeared to be extrapolating their most recent experience into the future and choosing predominantly on that basis," says Nathaniel Daw, a neuroscience professor at NYU who helped conduct the study.

The people with damage to the frontopolar cortex, however, "based their choices primarily on the cumulative reward history, not on the changes in the most recent outcomes," he says.

Without the ability to tap into one of the brain's most advanced reasoning centers, these people didn't try to outsmart the system or to guess the next outcome of an essentially random process.

The experiment wasn't designed explicitly to resemble a stock exchange, although its random structure does give it an uncanny similarity to real-world financial markets.

Among the mutual funds that were in the top half of performers in late 2009, according to Standard & Poor's, only 49% of them still remained in the upper half a year later; a year after that, only 24% were left. That is just about what you would get if you flipped a coin. Trying to find the winners is futile if victory is determined largely by luck.

When confronted with the unpredictable, however, the frontopolar cortex refuses to admit defeat. It draws on all your computational abilities to search for patterns in random data.

In the absence of real patterns, it will detect illusory ones. And it will prompt you to act on them.

No wonder so many investors find it hard to muster the willpower to buy and hold a handful of investments for years at a time.

But if "buy and hold is dead," as growing numbers of investors argue, it isn't clear what else is alive. In the lousy markets of the past decade, various alternatives such as "tactical asset allocation" (or market timing), mathematical risk-reduction techniques and even plain old intuition haven't worked out all that well, either.

Most of the folks who say buy and hold is dead don't talk much about their long-term returns. Instead, they stress how they have done recently, a tactic that for many potential clients has the same irresistible appeal as the last couple of pulls on a slot machine.

The solution to short-term thinking isn't to bash yourself in the forehead with a hammer, of course. But you can use your brainpower to your advantage.

Every investing decision you make should be the result of a deliberate process.

Start by creating a checklist of criteria that every stock or fund must meet before you buy or sell. Make sure you never buy or sell an investment exclusively because its price has gone up or down. In advance, list three reasons having nothing to do with price that would justify buying or selling.

After you sell, track the returns of those investments you sold, after you sold them, to see if they did better than whatever you bought in their place.

You don't have to trade like mad just because the people who grab headlines hold stocks for a few minutes or seconds at a time. Knowing the limits of your knowledge is the highest form of intelligence."

My Take

Buy-and-hold long term investing not only isn't dead. It's the only sensible way for individuals to build long term assets for retirement, college and other financial needs.

Warren Buffett says that in the short term the stock market is a voting machine, and that in the long term it's a weighing machine. The short term twists and turns in markets may be exciting, but they're just that---short term twists and turns.

The price of something only matters twice--- when it's bought and when it's sold. Everything else is just noise.

But the "experts" and traders wouldn't make any money if they accepted that simple fact. They live off our "frontoplar cortex" responses and their marketing abilities related thereto.

In the article above, the statistics are straighforward: of the top 50% of mutual fund performers in 2009, only one half of those were in the top 50% the next year and only 50% of the 50% were there in another year. Thus, 50% became 25% which in turn became 12.5%.  A game of chance would give the same odds or results and we wouldn't have to pay an "expert" for the pleasure.

So now I have provided some scientific evidence for why we're wired to favor today at the expense of tomorrow, even though it's frequently harmful to our "health." That said, historical statistical evidence of stock market performance over time says the same thing. As does common sense.

Reversion to the mean is real, as is frontopolar cortex influenced short term emotional behavior. Bet on your future self and hang in there when times are tough. This too shall pass.

My advice, as always, is to buy shares of good companies at good entry prices, watch the share prices appreciate over time (while getting a stream of increasing dividends, too), keep owning them as long as the basic reasons for buying them in the first place don't change, and prepare your future self to end up as a happy camper.

Down the road, your by then "present self" will be smiling and relaxed because of what your long ago "future self" decided was the best path to follow.

Outsmart the frontopolar cortex when investing, planning and behaving in all other aspects of life, in other words.

So maybe I'll go on a diet now, but maybe I'll just wait and start tomorrow.

We're all so very human.

Thanks. Bob.

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