“It is human nature to think wisely and act foolishly.” – Anatole France

SUMMARY

  • Despite rapid advances in technology, the human brain remains far more superior to even the most powerful supercomputer.
  • However, our brains have deficiencies that often lead to irrational and/or sub-optimal decisions.
  • Some of these biases or tendencies are related to social fears and pressures. Others are a function of how humans evolved over the eons. These can lead to reactions or emotions that were appropriate in pre-historic times but are often counter-productive today. They include excessive loss aversion and fear of missing out.
  • These flaws in our mental processing make the pervasive belief in efficient financial markets highly suspect since markets are only as rational as the underlying participants. By extension, this applies to the investment off-shoot of the Efficient Market Hypothesis: index-, or passive-, investing.
  • Yet, the growing popularity of index-based investment vehicles reflects the belief on the part of a growing number of both investors and advisors that markets are efficient and, consequently, unbeatable.
  • Evergreen disagrees with both the theory of efficient markets and the superiority of passive investing. Understanding our brain’s fallibilities and biases is crucial in avoiding the investment traps these create and in seeking to generate superior investment returns.

The Human Brain: Beauty Or Beast?

By Tyler Hay

How powerful is the human brain? Below is an image that graphically depicts how our minds stack up versus different processors including some of the world’s supercomputers.

Human Brain

Source: www.wired.com 
[drizzle]As you can see, despite all the available technology and computing power, science still can’t create a machine with more processing power than the brain of a rat. Our minds are tremendously complex and have evolved over the course of human history. In 2009, a South African neuroscientist named Henry Markram gave a speech where he proposed building a computer-based replica of the human brain. Scientists, who are correctly not known for their creativity, named it the “Human Brain Project.” The group of scientists that set out to achieve this feat received over 1 billion euros in funding. The project was featured in Wired Magazine and Markram himself delivered a stunning 15-minute TED Talk. In his speech, he describes the history of our brains, their evolutionary future, and his vision for helping science get a better grasp of how this complex and vast organ functions. Some have said that it was Markram’s son’s Autism diagnosis that ignited his passion to hack the unhackable.

The project itself has struggled, bogged down in political agendas (how unusual!), power struggles (equally unusual), and Markram’s borderline manic obsession with his ambitious goal of recreating our brain through the power of science and technology. Whether or not this particular project succeeds isn’t the point. It’s a sign that science has undertaken a journey that will eventually end with unparalleled access into something we know so little about.

However, for all the brilliance that’s packed into the three-pound organ inside our head, it comes pre-programmed with some serious deficiencies. Take for example a study done by (Kahneman and Miller, 1986), which analyzed the behavior of professional soccer goal-keepers in top leagues and championships. The focus was save percentage for these goalies during a penalty kick. After studying over 286 penalty kicks, the statistics went as follows: A goal keeper had a 12% chance of making the save if they dove to the right, 14% if they dove left, and a 33% probability if they stayed in the center.* These are compelling numbers. Goalies are two-and-a-half to three times more likely to make a save if they simply don’t move! Knowing this, what percent of the time do you think a goalie stays in the middle on a penalty kick? The answer? Six percent of the time! How could this be? The answer lies in what’s called our “action bias”. We feel compelled to at least look like we tried. Clearly, this is an emotional reaction to what should be a rational decision. It highlights something interesting about our decision-making process; it is affected by more than just reason. We hold preferences and social components as key inputs to the decisions we make as humans.

Let me give two examples that suggest we override sound decision-making because of the presence of a social pressure. In 1973, Solomon Asch—a Stanford professor—conducted the following experiment:

Human Brain

First, Asch arranged participants into groups of ten people. Then, he asked this question: Which line on the right (A,B, or C) is equal to the line on the left? (He asked his participants to give their answers out loud.) The answer was C. It was easy and nearly everyone got this right. (Only the fact that this study was conducted in the Bay Area during the ‘70s could potentially explain how anyone missed it!)

However, what they did next was fascinating: Actors, who were instructed to intentionally answer question with an incorrect answer, were placed in some of the groups. The participant (not knowing he/she was among nine actors in the group) would be asked to answer last. After hearing the actors mistakenly choose a line other than C, guess what happened? The accuracy plummeted. After watching these “actors” give incorrect answers, the accuracy dropped to 60% on a question that most eight year-olds would answer with ease. What changed? Social pressure. It caused individuals to severely doubt their decisions. If their confidence was shaken on a matter as straight-forward as this, imagine the weight our friends or colleagues carry on decisions far less clear.

At Yale, psychologists tried the following experiment on a group a Capuchin monkeys to see how far back our aversion to loss may be linked. In the first scenario, one group of monkeys was given a single cookie. In the second group, the monkeys were given two cookies only to have one cookie taken away from them. In both scenarios, the monkey groups ended up with one cookie. However, the monkeys much preferred scenario 1 to scenario 2. This aversion to loss lies deep in our DNA. Perhaps it comes from the fact that losing something 5,000 years ago meant more than losing something today. The stakes were higher. Losing back then might mean you went hungry, your mate was kidnapped, or you lost your life. Maybe we will always be wired this way.

Consider another experiment. Read the following description below and give your answer:

An individual has been described by a neighbor as follows: “Steve is very shy and withdrawn, invariably helpful but with very little interest in people or in the world of reality. A meek and tidy soul, he has a need for order and structure, and a passion for detail.” Is Steve more likely to be a librarian or a farmer?

Nearly everyone who reads this description confidently concludes that Steve is more likely to be a librarian than a farmer. The problem with this conclusion is it omits an application of basic probabilities. After all, if I asked you how many male librarians there are to male farmers, your answer may change. If I told you that there are roughly 20 male farmers for every 1 male librarians, most would regret the conclusion they

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