Your Money & Your Brain

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.

What Are The Odds?
It took two psychologists, Daniel Kahneman and Amos Tversky, to deal a death blow to the traditional view that people are always ''rational.''

Consider these examples:

1. Two bowls, hidden from view, each contain a mix of balls, of which two-thirds must be one color and one-third must be another. One person has taken 5 balls out of Bowl A; 4 were white, 1 was red. A second person drew twenty balls out of Bowl B; twelve were red, 8 were white. Now it's your turn to be blindfolded, but you can take out only one ball. If you guess the right color in advance, you will win $5. Should you bet that you will draw a white ball from Bowl A, or a red ball from Bowl B?Many people bet on getting a white ball, since the first person's draw from Bowl A was 80 percent white, while the second person drew only 60 percent red from Bowl B. But the sample from Bowl B was four times larger. That bigger drawing means that Bowl B is more likely to be mostly red than Bowl A is to be mostly white. Most of us know that large samples of data are more reliable, but we get distracted by small samples nevertheless. Why?
2. A nationwide survey obtains brief personality descriptions of 100 young women, of whom 90 are professional athletes and 10 are librarians. Here are two personality profiles drawn from this group of 100:Lisa is outgoing and lively, with long hair and a tan. She is sometimes undisciplined and messy, but she has an active social life. She is married but has no children.Mildred is quiet, with eyeglasses and short hair. She smiles often but seldom laughs. She is a hard worker, extremely orderly, and has only a few close friends. She is single. What are the odds that Lisa is a librarian? What are the odds that Mildred is a professional athlete? Most people think Lisa must be an athlete, and Mildred must be a librarian. While it seems obvious from the descriptions that Lisa is more likely than Mildred to be a jock, Mildred is probably a professional athlete, too. After all, we've already been told that 90 percent of these women are. Often, when we are asked to judge how likely things are, we instead judge how alike they are. Why?
3. Imagine that you and I are flipping a coin. (Let's flip six times and track the outcomes by recording heads as an H and tails as a T.) You go first and flip H T T H T H: a 50/50 result that looks exactly like what you should get by random chance. Then I toss and get H H H H H H: a perfect streak of heads that makes us both gasp and makes me feel like a coin-flipping genius.But the truth is more mundane: In six coin flips, the odds of getting H H H H H H are identical to the odds of getting H T T H T H. Both sequences have a one-in-64, or 1.6 percent, chance of occurring. Yet we think nothing of it if one of us flips H T T H T H, while we both are astounded when H H H H H H comes up. Why?

It's vital to recognize the basic realities of pattern recognition in your investing brain:

• It leaps to conclusions. Two in a row of almost anything—rising or falling stock prices, high or low mutual fund returns—will make you expect a third.
• It is unconscious. Even if you think you are fully engaged in some kind of sophisticated analysis, your pattern-seeking machinery may well guide you to a much more instinctive solution.
• It is automatic. Whenever you are confronted with anything random, you will search for patterns within it. It's how your brain is built.
  It is uncontrollable. You can't turn this kind of processing off or make it go away. (Fortunately, as we'll see, you can take steps to counteract it.)

Researchers Schultz and Read Montague, along with Peter Dayan, now at University College London, have made three profound discoveries about dopamine and reward:

1) Getting what you expected produces no dopamine kick.

2) An unexpected gain fires up the brain.

3) If a reward you expected fails to materialize, then dopamine dries up.

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An Interview With Jason Zweig