Why Your Brain Makes the Wrong Decision at the Worst Time

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Why Your Brain Makes the Wrong Decision at the Worst Time
Neocortex vs. Basal Ganglia

By Bob Stokes
Thu, 31 May 2012 15:45:00 ET

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We all love a bargain...

...Except when it comes to stocks.

Robert Prechter and Wayne Parker believe they know why. They co-authored the seminal paper, The Financial/Economic Dichotomy in Social Behavioral Dynamics: The Socionomic Perspective, published in The Journal of Behavioral Finance.

The reason boils down to uncertainty. We know what our fruits and vegetables should cost at the grocer's, but we're far less certain about how much to pay for a blue-chip stock or shares in an S&P 500 Index fund. Prechter and Parker put it this way:

When certainty about personal valuation applies, people maximize utility and markets seek equilibrium. When uncertainty about others' valuations applies, people herd and markets are dynamic. The first state is common in markets for utilitarian goods and services; the second is common in markets for financial assets.

So how does our mind work in decisions that involve certainty vs. uncertainty? Well, as Prechter and Parker explain, very different regions of the brain take over -- literally.

When we spend money as consumers, we depend on the neocortex region of the brain, where our ability to reason resides. For example, if we shop for groceries and see our favorite fruit on sale at a 40 percent discount, we think "That's a good deal. I make the best use of my money by buying it now." And, if we hang around to watch how other shoppers behave, we see that particular item sell out sooner than usual. In other words: The demand for consumer goods rises as the price falls.

But when we spend money as investors, our brain relies on the more primitive region -- the basal ganglia -- which drives unconscious behavior such as herding. Let's say that 30 minutes after the stock market opens, we see that the blue-chip stock we own is down 20 percent. We know that shareholders are fleeing the stock. The basal ganglia screams, "They know something I don't. I'd better sell too." In this case, demand for the asset FALLS as the price falls. Why? Because in speculative markets, assets have no true utility. An investor buys it today in the hope that it will be worth more to another investor tomorrow. But that future value is uncertain, so the brain defaults to herding.

The sketch of the brain shows the locations of the conscious, reasoning neocortex and the unconscious, impulsive lower areas:

Is the reasoning function of the brain completely absent during the buying and selling of financial assets? Robert Prechter answers the question this way in the April 2004 Elliott Wave Theorist:

The rational areas of the brain do play a role in the herding process. They provide rationalization. Without this service, the herding impulse would encounter resistance from the dictates of reason. But research shows (see Chapter 8 of The Wave Principle of Human Social Behavior) that unconscious forces are fast and powerful. They developed through eons of evolution and have kept countless species alive. People unaware of the power of these forces simply employ their reason to excuse the actions that their unconscious impulses impel them to take. This is what most investors, money managers, economists and media commentators do. If a statement about market causality appears to make sense, they use it as a 'reason' for their views and actions.

For example, when the Dow Industrials were up 125-points on Tuesday (May 29), the financial media said the reason was hope that China would take steps to reverse their economic slowdown. But what happened to the European debt crisis? That's the "reason" for the previous trading day's decline. It's not that Europe's financial problems disappeared for a day, but that the media couldn't use that as a reason for the market being up. Yet when the Dow fell by 160-points on Wednesday (May 30), the focus was on Spain's borrowing costs. The "hopeful" China story just went away.

These are rationalizations, not reasons. News reports don't explain the real reason why markets trend -- namely, the collective psychology of market participants.

These trends are patterned, and they are probabilistically predictable. What pattern do we see unfolding in the market charts now?

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Tags: Elliott wave, herding, investment decisions, Robert Prechter, stock indexes, Traders

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