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Your Brain Is Like Tiger Woods: Impressive ... and Embarrassing

Alex Pape — Tue, 13 Sep 2011 14:15:00 EST

Your brain is like Tiger Woods -- impressive in its achievements, seemingly well-suited for its tasks, but nonetheless prone to embarrassing stunts with disconcerting frequency.

It's no wonder: Charged with making sense of the world around us, our brains face an arduous task. Given the sheer torrent of information gushing toward us as if from a fire hose aimed at a teacup, our mind can't help but take shortcuts. And those shortcuts can manifest with particular rancor in our investment decisions.

Five Mental Shortcuts That Will Hose Your Returns

Every time we take in new information about a company -- be it from an article, television program, press release, or elsewhere -- our brains try to scuttle down their well-worn shortcuts. It scrambles to form opinions and make decisions. And all too often, it steers us down the exact wrong path.

In a volatile market all too ready to acvtivate our mental gimmickry, it's more important than ever to be able to recognize the tricks our brains play on us. Before you make a trade, be on the lookout for these five "brain games."

1. Recency bias
When you overweight recent events when drawing conclusions, you are falling prey to recency bias. For example, oil companies have been strongly profitable in the last couple quarters. BP (BP) just turned in a $101 billion quarter, the first time the company has cracked into 12-digit range since 2008. But to conclude that oil companies make great investments would be myopic. Of course profits are high right now -- oil is near $90 a barrel -- but this is a cyclical industry, one in which peaks are eventually and inevitably followed by troughs.

2. Inconsistency avoidance
The inertia of our past decisions can be a powerful force. Quite simply, we don't like to change our minds. This can be positive at times -- for example, an intern labeled as "smart" will strive to the ends of the earth to maintain that reputation (not that we used such mind tricks on our own interns...). But unless we are vigilant, we can also anchor to past decisions that might not have been sound in the first place, or fail to update our thinking in light of new information.

3. Influence from mere association
A hypothetical new manager at Macy's (M) sees this chart of quarterly sales versus the average temperature at company headquarters in Cincinnati, Ohio:

The manager concludes that cold temperatures induce customers to spend more money at Macy's stores. So he drafts a proposal to open new stores only in cold climates.

This is, of course, ridiculous. Macy's sales spike higher in the winter because of holiday shopping -- not because of the temperature. The holidays cause the higher sales; the weather is merely associated with sales. Our overzealous manager is confusing the two. As absurd as the mistake may seem, such investing conclusions are drawn all the time. Don't become a cautionary tale. Focus on what actually drives a business, not the irrelevant associated events.

4. The "loss double-ouch phenomenon"
In these volatile markets, think about your own reactions to 3% down days versus 3% up days. If you are anything like most people, the down days sting viciously, but the up days are only mildly pleasant. Research has shown that we feel losses twice as strongly as we do gains. When you combine this emotional reaction with the human instinct to avoid pain and seek pleasure, a problem becomes evident: If pain is more painful than pleasure is pleasurable, our risk tolerance can be driven to detrimentally low levels.

5. Ambiguity avoidance
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People do not like ambiguity. Actually, let me rephrase that: We loathe ambiguity. To counter it, our brains want desparately to reach a conclusion -- often any conclusion -- quickly. This is, in my opinion, the worst of the five mental shortcuts I've outlined in the article. Unfortunately, it is also the most powerful, because our propensity to avoid ambiguity both feeds on and is amplified by the other tricks.

Consider why: A brain motivated to reach a conclusion in the face of conflicting evidence could easily resort to relying on only the most recent data (recency bias), clinging to a past decision (inconsistency avoidance), looking to an irrelevant outside factor as an indicator (influence from mere association), or holding on to a low-conviction, losing stock simply to avoid realizing the loss (the loss double-ouch phenemenon). To keep these ill-effects at bay, always remember that the best conclusion is often no conclusion at all.

Our brains are powerful tools, but they have their shortcomings. Since investing is all about good decision-making, you want to make sure your mental gearbox is in top working order. As you process information, I encourage you to keep your brain's mental gimmickry in mind. Your brokerage account will thank you.

Neither Alex Pape nor The Motley Fool owns shares of any company mentioned. Follow all of Alex's thoughts and trades on Twitter.

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Non-Biz Books to Help You Think More Clearly in a Crisis

Alex Pape — Tue, 09 Aug 2011 16:30:00 EST

Filed under: Investing Basics, Books, Investing

In stressful circumstances the brain works in wonky ways. In fact, those who are most likely to survive in the wilderness are not the ones with the proper tools and training, but the people who are able to control their state-of-mind.

In Deep Survival: Who Lives, Who Dies, and Why, author Laurence Gonzales shows in case after case evidence that mental fortitude makes the difference between life or death; between surviving or thriving. The parallels to investing -- especially in volatile markets -- are striking, not only in Gonzales's book, but other not-about-investing-but-still-applicable books about the inner workings of our brains.

Here are nine other reads will help you work through the tricks your mind plays on you in stressful situations (couldn't come at a better time, eh?) and show you how to overcome them. Not only will they make you a better investor, but they'll also help you learn to make smarter decisions in other parts of your life.

1. How the Mind Works

For those of us without doctorate degrees, this is a great read on the progress of modern brain science. Steven Pinker argues that how our minds work is best understood as part evolution, part computer-program, illustrating his lessons with phenomena ranging from the correlation of height to salary to optical illusions. Understanding how our brains work helps us understand how we make decisions -- and allows us to improve the shortcomings of that process.

2. Synectics: The Development of Creative Capacity

Published in the '60s amid "exciting new research" about what spurs creativity, this book is just as relevant today as it was 50 years ago. Author William Gordon makes a compelling argument that creativity is boosted dramatically when people understand the psychological process behind that creativity, and he explores factors that contribute to creativity in individuals and groups.

3. Innumeracy

Author John Allen Paulos sets about trying to close what he considers an appalling gap between the numerical dependency of our society (think science and computers, for starters) and the mathematical illiteracy of its citizens. Investing is by no means all about the numbers, but just as you should learn French before trying to read L'Étranger in the original, you should make sure you understand the intricacies of the numerical lexicon before entering the market.

4. No Two Alike: Human Nature and Individuality

Where do our personalities come from? Judith Harris dispels a number of theories, including one of general differences in "environment." She offers her own theory, laced with scientific research, arguing that we are a function of what she calls our "systems" of relationships, socialization, and status. For anybody curious about why they are the way they are, this book is tremendously thought-provoking.

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5. The Selfish Gene

The Selfish Gene does not reject common evolutionary ideas but rather builds on them. Richard Dawkins takes a fresh look at natural selection and argues that a world defined by selfishness is not necessarily a world only of ferocious competition, deception, and exploitation, but also one of altruism and progress. Written for the public and not just for disciples of Darwin, this is book offer insights into the forces that shape our world -- and that certainly encompasses investors.

6. Drive

Common knowledge about what motivates us is wrong. Drawing from a mix of psychology, economics, and sociology research, Daniel Pink debunks the logic behind carrot-and-stick incentives and argues that once basic survival needs are met, we are motivated primarily by a desire to develop and the prospect of mastery. Whether you want to make sure your own motivations are aligned or are trying to motivate someone else, Drive is a must-read.

7. The Psychology of Judgment and Decision Making

How do we reach decisions? More importantly, are we any good at making decisions? This book takes on these questions directly and offers specific ways to improve your own decision-making process. It's so relevant to investing that The Motley Fool requires all new investing analysts read it.

8. Genome

With the human genome now mapped, people have a ton of questions -- and Matt Ridley gets right into the juicy ones, focusing on how our DNA affects things as disperse and contentious as intelligence, sex, and cancer. Ridley isn't writing for scientists, and he isn't presenting new theories; he simply takes a hard look at the evidence now available and makes connections.

9. Influence: The Psychology of Persuasion

What makes a person say "yes" to another's request? Influence is a well-researched look at the tactics that work and why, breaking them down into six categories of psychological influences on our behavior. Invaluable to anyone who wants to make a convincing argument (and that pretty much includes everyone), this book also offers a tremendous edge to you when you are the one being convinced, allowing you to understand the ploys being played against you.

Alex Pape is an analyst on Motley Fool Pro and Motley Fool Options. You can follow all Alex's articles on Twitter.

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