In one of my previous blogs I had written that there are mainly 5 major factors which affect stock markets (or price of any thing which is determined by free market forces) and those are – economic factors, monetary factors, fundamental analysis, technical analysis and psychological factors. There has been lots of research, books and material available on the first 4 factors but the most important and I would say the deciding factor is the 5th one i.e. psychological factors and very little has been written or appreciated on it. Whatever may be our method of investing, whether fundamental or technical or any other, do we actually do what we had initially decided to do. What if the price goes against our decision – do we still stick to our conviction? For example, an investor after doing full fundamental research on a stock whose current price is Rs.100 concludes that its value is Rs.150 and hence buys that stock. Now, for no fault of the stock and all the original fundamental factors being intact, the stock falls to say around Rs.75 because of the overall market fall or some humour surrounding the stock etc. Then what does the investor do – does he / she panic and exit the stock at a loss or rather because the original premise for which he / she bought the stock has not changed, simply hold on to the stock or infact buy more. That deals with “Investor Psychology”. Whether in stock market or any other walk of life, beating the market is not that difficult but rather beating our “own selves” is the real difficult part. Beating ourselves simply means mastering our own emotions and the ability to think rationally and independently in the face of all the noise surrounding us.
Psychology is a big subject and beyond the scope of this article but very broadly we have to understand our own selves (whether we are speculator, trader or investor, our strengths and weakness and then consolidate on our strengths and minimize the weaknesses). We have to not believe any expert or guru at face value (including myself although I don’t claim to be an expert but just a student of investing), we should have independent thinking, be patient and persistent, should know how to follow the trend and when to go contrary, how to profit from news breaks and media (rather than just getting carried away by the noise around us), should know how to deal with brokers and fund managers (remember its their “compulsion” to be always bullish or not bearish) etc. And remember that the biggest enemy of an investor is pride – the thought that he / she can never go wrong and not accept his / her mistakes (if I go wrong on any of my views then I put the confession in italics because even if the reader misses where I might have gone right, he / she should know where I have gone wrong). Market is the biggest deflator of our egos. The great Mr. Charles Dow (founder of Wall Street Journal and the all season “Dow Theory”) had once said that “pride of opinion has been responsible for the downfall of more men on wall street than any other factor”.
We may talk a lot about psychological behavior and how it is a very important factor in determining our success not only as an investor but also in other facets of life but do we really know how to develop our “brain psychology” so that it works for our benefit and not otherwise. I am not a doctor, scientist or psychologist by qualification but I do think that understanding human brain psychology is of utmost importance in the investment world as well as in any field – basically its most important for us humans to succeed as social animals. Now, what is human psychology, for that we have to understand our human brain and how it functions because finally we all our controlled by our brains (conscious and subconscious minds). Dr. Paul MacLean, a great neurologist and researcher, has brought the concept of “Triune Brain” or the three layered brain.
The three major layers or 'brains' were established successively in human evolution. Each of the three brain layers represents a distinct evolutionary stratum that has formed upon the older layer before it like an archaeological city. The oldest layer is the reptilian (non-thinking) brain, the second oldest is the mammalian (emotional) brain and the most recent is the cerebral (thinking) brain. Each of the three brains is connected by nerves to the other two. Each brain operates as its own brain system with distinct capacities for perceiving and responding to the environment and each can become dominant depending on the circumstances. The major problem with human psychology and irrational behavior is that the integration and coordination between the three brains is inadequate, a genetic problem in our species. This has implications for human development.
Reptilian Brain or R-complex: The reptilian brain is the oldest layer - the most 'primitive' of the three brain components and makes up the entire brain mass in reptiles. The reptilian brain consists largely of the structures. Functions of the reptilian brain are related to physical survival and body maintenance - digestion, reproduction, circulation, breathing, stress responses, territorial instincts, social dominance, ritualism, social dominance, status maintenance, deception, tendency to follow precedent, awe for authority, social pecking order behavior, compulsiveness, deception, prejudice and resistance to change, rigid, obsessive, compulsive, paranoid etc. The functioning of the reptilian brain is activated when the organism perceives threat and the needs for survival and safety predominate. This part of the brain is active, even in deep sleep. Kindly note, this is the only part of the brain which is NOT in human control – lot of bad human behavior, wrong decisions and other psychological problems happen because of the reptilian brain and a not proper functioning mammalian brain (explained later on).
Mammalian Brain or limbic system: The second layer middle part of the brain occupies the lower fifth of the human brain and developed with the evolution of mammals. As a brain system, the mammalian brain consists of a series of brain structures around the brainstem which contains the Reptilian brain. The mammalian brain functions in primary seat of emotions of fear, joy, rage, pleasure and pain, attention, and affective (emotion-charged) memories, what gets your attention, unpredictability, feeding, fighting, fleeing, memory and sexual behavior.
Cerebral cortex or neo-cortex or rational thinking brain: The third layer which occupies five sixths of the brain is known the 'neocortex' or the 'cerebral cortex'. The cerebral brain is the latest evolutionary development of the brain. The cerebral brain is involved with most mental activity, including spatial and mathematical thinking, meditating, dreaming, remembering, processing and decoding of sensory information. The cerebral brain is divided into left and right hemispheres -left and right brain. The left hemisphere is linear, rational, and verbal and controls the right side of the body. The right hemisphere is spatial, abstract, musical and artistic and controls the left side of the body. For example, generally speaking, highly educated people like doctors, lawyers, engineers, Chartered Accountants etc have highly developed “left cerebral brain” while persons involving in creating professions like actors, singers, painters, musicians etc have more developed “right cerebral brain”.
The interaction of the three brain layers forms the biological basis for the interaction of concepts, emotions and behaviors which make up the learning process. The reader might think that the cerebral brain dominates the mammalian and the reptilian brains. However, you will be surprised to read that the cerebral brain generally is the weakest of the three and that the mental functions of the cerebral (thinking) brain can be hijacked by the functions of the other two brain layers. This is the main reason while totally rational individuals take totally irrational decisions under specific situations of life (including investments). For example, the reptilian (non thinking) brain runs automatically and not in our control (because it controls vital survival functions like breathing, digestion, circulation, reproduction etc) and it is that part of the brain which immediately starts functioning even without our knowledge. Suppose, somebody gave you a complex mathematical problem, you will not have a direct answer, you will have to activate your cerebral (thinking) brain to solve the equation. On the other hand, the reptilian brain immediately gets activated even before we realize – suppose you just see picture of a McDonald burger, your mouth might immediately water although your cerebral (thinking) brain knows that there is no burger but the reptilian brain had stored the real burger picture in its memory which you might have eaten in the past and associates the photo picture with it. Hence, although we may be rational human beings and like to use our cerebral (thinking) brain but most of the times are fooled by the automatic images of the reptilian brain which “fools” the mammalian (emotional) brain to re-direct the power to it instead of the cerebral “thinking” brain.
Now, we will consider this in light of a stock market example. Let us take the example of the past 4-years stock market which might be still fresh in investor’s minds. We all know that to make money in stocks (or for that matter anything) we have to buy it cheaply and sell it costly. This rule we apply to almost all items as we go on extended shopping during times of “discount sales” and avoid buying when the items are unnecessary costly. However, why we are not able to apply this simple logic to stocks. Just consider, many of us might had invested when the Sensex was around 21000 in December 2007 when infact we should have sold. Then 1-year down the line, many of us “frustrated” investors might have sold at 8000 Sensex when infact we should have bought it. The same investors might have again purchased at close to 20000 Sensex in October 2010 which they had sold at 9000 Sensex in December 2008. And now in November 2011 those same “frustrated” investors might be contemplating of exiting those loss making investments at 15000 Sensex. Now, why do we rational investors behave in such an irrational manner. This is related to the three different brain systems explained above and their interaction and dominance of one above the other. Now, let us see what is actually going on through the investor’s mind at each of the different stages. Kindly note, the cerebral (thinking) brain is the weakest and unless consciously activated and used succumbs to the power of the other two brains. At 21000 Sensex in December 2007, the reptilian brain automatically tells the other two brains that the market has been going up and it shows the picture of the market going up (all pictures are stored and automatically retrieved in the reptilian brain). Next in line is mammalian (emotional) brain which receives the “signal and picture” from the reptilian brain that the market has gone up. The mammalian brain is emotional and there are feelings of joy of earning money in the stock market or fear of loosing money / not earning money. Now, at this point of time the cerebral (thinking) brain might be saying that logically the stocks are costly based on whatever evaluation like fundamentals, technicals etc but its voice is very weak amongst the three brains at this point of time. In essence the mammalian or emotional brain is the most powerful of the three because it now has the power to re-direct the situation back to either the reptilian (non-thinking) brain or the cerebral (thinking) brain. In most of us humans, the joy of thought of earning more money which the reptilian brain has induced on the mammalian (emotional) brain is much stronger than the real correct picture which the cerebral (thinking) brain is portraying. Hence, is majority of us the mammalian brain re-directs the power to the reptilian brain and that explains the behavior that although logically we know that at 21000 Sensex we should be selling and not buying but we still actually in action buy and not sell. This kind of behavior is associated with most of the actions which we human beings do in our day-to-day life under the influence of our reptilian (non-thinking) and mammalian (emotional) brain and ignoring our cerebral (thinking) brain in the process to our own peril.
Now, let me give another example related to the triune brain and a big social menace – sexual abuse and rape. When a male / female observes an attractive handsome / beautiful person of the opposite sex – the person unconsciously may get some kind of immediate sexual arousal. This is because the reptilian brain which stores the images and pictures and not in our active control immediately flash backs some kind of image picture of any person of the opposite sex which the person under question might have seen etc in the past and then he / she relates that picture to the person whom he/ she is currently viewing which in turn leads to some kind of excitement / arousal / interest in the person and upto here is natural, unconscious and uncontrollable. From now onwards what happens within the 3 brains is most important. The picture from the reptilian brain then goes to the mammalian brain which is the emotional brain which then attaches the joy of what it had or can experience with the person of the opposite sex in the past and at the same time it also experiences the fear of doing something wrong etc. The cerebral (thinking) brain is all the while saying that it should just keep quite and not proceed any further because it is wrong – however the cerebral brain is the weakest of the three unless the other two brains have relinquished their power in its favour. Now, in the majority of us, the mammalian (emotional) brain will not heed to the reptilian brain and give the power to the cerebral (thinking) brain and hence the person will sit quietly. However, in few persons, the mammalian brain will give the power to the reptilian brain which in turn will lead the person to do some wrong act like rape although his cerebral brain had been all the while stating that it is wrong. Further, in a normal person the thinking is in a wide perspective but when he / she gets sexually aroused then due to the release of certain “natural drugs” like dopamine, norepinephrine, testosterone, oxytocin and serotonin the thinking becomes narrowly focused only on the sexual arousal to the exclusion of other thoughts like social values, Government laws, family, work etc.
So, whether in investments or any other phase of our life, the problem happens with over-active reptilian brain and a weak mammalian brain. Hence, the key to succeed in investments or for that matter anything in our life is to slowdown our reptilian (non-thinking) brain, have a very strong mammalian (emotional) brain so that it can re-direct the power to our cerebral (thinking) brain.
Safe Investing and Happy honest Living!
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