The Brains Behind Investing

Warren Buffett once said, “The greatest Enemies of the Equity investor are Expenses and Emotions”. Now more than ever, it can be seen that emotions have a huge part to play in financial markets, following many abnormal market movements in the last 12 months.

But what is the theory behind it, and how big of a role do emotions play in financial markets?

Robert J. Shiller published a famous article titled “Do Stock Prices Move Too Much to be Justified by Subsequent Changes in Dividends” in 1981, which concluded that stock prices move far more than their dividend pay-outs, thus psychological biases must drive markets. Research on the human brain, in particular that of Paul D. MacLean, has helped to explain why.

Throughout time, humans have evolved 3 distinct parts of the brain. The Reptilian Brain, which controls the body’s vital functions. The Paleomammalian Brain, which controls motivations and emotions. And finally, the newest part, the Neomammalian Brain. This part of the brain controls logical reasoning, which is an essential quality to have when making big decisions; whether they are investment-based or on general life

Excessive emotional stimulus overrides the Neomammalian Brain, which impacts logical reasoning and leads to abnormal or extreme reactions. From an investor’s perspective, when markets are rising fast, we see high levels of emotional stimulus. People suffer from the fear of missing out or become overconfident and pour money into stocks that they think, due to recent trends, will continue to rise for a long time to come. However often we see that due to rapid increases in price, these stocks become heavily overvalued, and a selloff/correction occurs soon after as seen recently in the Electric Vehicle market.

We also see similar effects when markets are correcting or even crashing as they did in 2008. When investors see prices plummeting, and their money vanishing, this often leads to “panic selling”, where people sell their assets early so their losses don’t grow, rather than holding a falling asset and waiting the bad times out. The saying “buy high, sell low” has become a joke when referring to inexperienced investors, who often buy a fast-rising asset too late, and panic sell in the middle of its crash for a significant loss.

The adaptive market hypothesis was introduced in 2004 by Professor Andrew Lo, which captures the behaviours seen above. His theory stated that the majority of the time logical reasoning in markets is stable. Stocks follow relatively consistent and reflective price patterns, and investors with any sort of experience can determine which companies are a good investment and which companies are not; this is known as the “efficient market hypothesis”. However, when markets experience extreme conditions such as prices rising or falling at a significant rate, markets tend to follow what is known as “behavioural finance” theories which look into psychological influences on markets.

Experienced investors have the capability to remove emotion from their decision-making, and therefore, tend to be most successful. Michael Burry is a prime example of this. In 2008 he was one of the only people who predicted the housing market crash. Most of the country was in a state of euphoria due to many years of successful gains and were riding a wave of overconfidence and, towards the end, naivety in assuming the housing market could never crash. Burry was not sucked into the myth and analysed the market, saw what was unfolding in front of him and shorted it (bet that the market would go down). In 2008 when the market did crash, and people were losing money, Burry saw a 489% profit on his credit default swaps.

Due to his immense success, when Burry speaks, people listen. He has spoken out recently in regard to the current state of the market, believing that the “mother of all crashes” is inevitable as indexes climb to new all-time highs. Furthermore, he has opened another “big short” position. Long puts on $500million Tesla shares.