I first started dipping my toes into value investing in 2001, shortly after I had purchased my first index fund after reading “A Random Walk down Wall Street” by Malkiel. I had saved a modest sum, and wanted to create a nest egg so that I would be able to do what I wanted, rather than do what other people wanted of me for a living. I was looking for financial freedom and autonomy. These hopes were dashed 3 months later, when the index fund plunged 20% in the midst of the stock market crash, and I bailed out of the fund in a panic. I started reading many other investment books in the search for a better investment strategy than an index fund approach, stumbled upon value investing, and saw the light.
Interestingly, modern neuroscience research has begun to reveal the neural underpinnings of my initial investment foray. It turned out that the human brain has evolved as a prediction machine, driven mainly by the prefrontal cortex. The human prefrontal cortex has arisen relatively recently in evolution as a brain region that processes data and uncovers patterns, and during evolution, it had formed an especially rich set of connections with the limbic system, the seat of emotion and motivation in the brain. While prediction is the primary function of the human brain, we are driven mainly by our emotions to perform this function. The human brain has an actual hunger for information and certainty, similar to our hunger for food, water and sex, but less intense. Our brains actually receive a little squirt of dopamine each time the world gets a little more certain, which we interpret as pleasure. Hence, many people spend hours compulsively reading the internet in the quest for information, or solving Sudoku or crossword puzzles. Each time a puzzle is solved, a little uncertain piece of the world has been made more certain, and we receive a shot of happiness. Entire industries exist to satisfy our cravings for certainty, including psychics, palm readers, and black boxes that predict stock market movements. We can also channel this hunger for certainty and autonomy in more productive ways. Many entrepreneurs have started their own businesses in the pursuit of autonomy and certainty. Although many entrepreneurs work longer hours and at lower pay compared to when they were employed, many also report being happier and more fulfilled because of the autonomy they now enjoy. And of course, once in a while, an entrepreneur’s business actually makes it big, fulfilling their dreams of financial freedom.
Unfortunately, the flip side of our hunger for certainty is our fear of uncertainty. The same limbic system that provides pleasure for certainty also causes fear and pain when we perceive an uncertain situation. As anyone who has been paralyzed by fear when trying to ask someone out on a date can attest, the limbic-system based fear emotion is far stronger than any other thought process. While we can cognitively recognize that in many situations, the upside is substantially higher than the downside, the introduction of an uncertainty element simply swamps out rational thought. For example, in this experiment, participants were willing to pay $45 for a $100 Barnes and Noble gift voucher, and $26 for a $50 gift voucher. However, when they were asked how much they were willing to pay to take part in a game in which they had a 50% chance of winning the $50 voucher, and a 50% chance of winning the $100 voucher, they were willing to pay only $16. The mere injection of uncertainty into a situation can lead to irrational decision making. As value investors, we try to take advantage of this kind of irrationality. More importantly, we have to properly control and channel the fear reaction that arises in us whenever our own holdings plunge. In future posts, I will outline several of the cognitive tricks I use to properly manage the fear in my investing life.
