I was having a great back and forth conversation with Dividend Growth Investor (DGI) on the recent article on temperament. We went from the comment section into long and detailed emails on our position surrounding investors’ temperament and our opinions on why or why not the “average” investor might be fairly terrible investors, from a total returns perspective. Half way through the tome of an email reply I had written back, I started getting into the basics of the brain. When gathering mental models, it’s not enough just to read and understand finance, business, and accounting – ultimately, you need to have a base level understanding of all the major ideas in every field, from biology and physics to psychology and anthropology. The amygdala hijack – term coined by Daniel Goleman in his book Emotional Intelligence – is a blend of ideas arising out of biology, neuroscience, and psychology. For me, the concept of the amygdala hijack really illuminates why investors might typically buy high and sell low, leading to abysmal returns.
Stimulus & Reaction
When I wrote about the shame and resentment I felt growing up in Canada as the child of first generation immigrants, that visceral reaction I felt towards my identity? That was the amygdala hijack in action.
This was the image I drew up for that story:
Look at that diagram closely, as it will relate back to what I’m about to explain.
Systems 1, 2, & 3
In the case of investing, why does greed drive irrationality? Why does the market suffer from boom and bust cycles? Why does something like the Dot Com Bubble occur? Why do people bid up stocks to irrational levels? And just as irrationally, why do many of these investors sell out in a panic at losses as the bubble deflates? To answer these questions, we need to understand the brain.
The brain is made up of 3 systems: System 1, System 2, and System 3.
System 1 is comprised of the oldest parts of the brain, like the brain stem and cerebellum, responsible for all the basic functions that occur automatically in our bodies, like breathing and digestion. These are ingrained, automated, instinctual processes and we have no control over System 1.
System 2 is the next “newer” layer over the parts revolving around base functions of an organism. System 2 houses the amygdala. The amygdala is the emotional sentinel, able to hijack the brain in times of need (a great survival mechanism). We have a little control over System 2.
System 3 is the cerebral cortex, the newest areas of the brain – exclusive to mammals – where our higher level functions, rationality and logic spring from. We have control over this area, but it is in large part superseded by System 2.
The way evolution works, as the brain evolved from more primitive to advanced, it didn’t get rid of the older parts of the brain. Instead, the newer parts “layered” on top of the older parts. The older parts still perform important functions for survival, so they remain with us. And thus, the crux of our problem of being a species that runs 21st century software on hardware that was last upgraded millions of years ago. This is what plagues us with sin, folly, and irrationality as a species.
The Amygdala Hijack
When we receive stimuli through our various sensory organs, the information travels to the thalamus, which acts as the brain’s air traffic control. From there, the amygdala gets first dibs at the stimuli before it ever reaches the cerebral cortex. This is a survival mechanism that ensures that we are provided with the opportunity to react to our environment long before the rational brain has time to mull things over.
The amygdala has a pretty thin hair trigger and has been found to be quite sloppy: prone to distortions and over-reactions. It works on the basic survival algorithm of “better safe than sorry.” Goleman states in his book that it can respond to a threat stimuli in as little as a few milliseconds. That is a great thing as you can imagine that our ancestors out in the savanna did not wait around to logically think things through if they perceived any threat stimuli coming out of that bush over there. You book it out of there and think things through logically later. Your survival depends on it.
Even though we have a cerebral cortex, where logic and rationality arise out of, the way the brain is layered and wired – new parts on top of older, more primitive parts – we cannot yet escape irrationality. This is because those older areas of the brain are hardwired into our system because it was beneficiary for our survival as a species. And evolution does not move quickly: it moves at glacial paces relative to our perceived notions of time. Thus why we are a species running incredibly advanced software – our culture – on extremely primitive hardware – our physical bodies.
I’ll keep this brief as I don’t want to dive into a whole new series of mental models that reside in the realm of behavioral finance, but there is an important connection here with the amygdala hijack.
I was rhetorically asking earlier why investors suffer from irrationality? The amygdala hijack is major part of the explanation. Another resides with how the amygdala hijack can be amplified through interaction with other human beings, especially if they too are suffering amygdala hijacks.
Herding behavior, such as when stocks are bid up or down to irrational prices, is the amygdala hijack gone haywire. As people look around and see others being greedy or fearful, it causes confirmation bias and the amygdala is triggered to make emotionally-driven decisions rather than logically and rationally driven decisions. Recall how the amygdala gets first dibs on stimuli reached in the brain. If that stimuli is greed or fear, the emotional reaction is the first and very powerful reaction the investor receives.
If you are ignorant of these effects, you are very susceptible to making poor decisions – buying high and selling low – as you are just letting the automated survival script play, which is not based on logic or rationality.
If you are ignorant of these effects, you make poor investment decisions because your automated survival script is defaulted to “better safe than sorry, dump the stocks, get the cash now, I’m scared and I don’t care, and worry about the repercussions later.”
With this understanding, it is not difficult to see why most people should be mediocre investors, because without proper education and training, they are much more prone to System 2 responses to stimuli from the markets.
If you recall the first image on stimulus and reaction, the smaller that space between stimulus and reaction, the more prone you are to amygdala hijacks. It takes patience, learning, introspection, and practice to increase that space between stimulus and reaction.
The intelligent man may have the same violent and unsocial impulses as the ignorant man, but surely he will control them better, and slip less often into imitation of the beast.
– Will Durant
Possessing a large gap between stimulus and reaction is the foundation of a solid temperament not just for the enterprising investor, but for the enlightened human being.