The Investment Scientist

Are market prices an indicator of fundamentals or just feelings?

Posted on: July 25, 2012

Brain collage

I received this question from a subscriber to my monthly newsletter. To answer it, I must take a detour to our human brain structure.

We actually have three brains in our head!

In the center is the reptilian brain that we share with fishes, birds, and reptiles.  It deals mostly with “housekeeping” and instinct, such as body temperature and hunger. The fight-flight-freeze fear response is handled here as well.

In the middle is the mammalian brain that we share with dogs, cats, and horses. It deals with feelings and memories, such as fear.

What distinguishes humans from animals is the “cortex,” especially the “prefrontal cortex” that handles language, logic, numbers, etc.  It’s the thinking brain.

The more primitive is the brain, the more robust and automatic. It takes a lot of effort to read an annual report (using your thinking brain), but it takes much less effort to be fearful (using your mammalian brain) when prices are tumbling.  Many people sell their stocks when they are afraid; that’s their reptilian brains at work.

For as long as we humans have three brains in our head, market prices will be an indicator of fundamentals, feelings, and instinctive reactions.  To be a better investor, it’s crucial to be aware which brain is at work.

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2 Responses to "Are market prices an indicator of fundamentals or just feelings?"

In my experience when I invest based on my feelings, I get burned. About 6 years ago I got revved up about green energy. Windmills and solar panels danced through my head. I found a fund that was green and a couple of individual stocks. I lost my shirt because it was a well thought out, cerebral/emotional idea.

On the other hand, in December of 2008 I was vacationing in Phoenix, AZ. My friend is a fan of Cabela’s and especially their firearms department. I had never owned a gun and only fired one a few times. I witnessed people standing in line for 2 hours while ten salesmen tried to service the que. I had never seen anything like it before. It was like the grand opening of the first Dairy Queen. I realized there was something happening I was completely unaware of.

When I returned I looked around for an American firearms company that was poised to grow with this customer demand. There were two Smith & Wesson (SMHC) and Sturm, Ruger, & Co. (RGR). I did some home work and at that time I chose RGR. I purchased them at about 11.50/sh. It is hard to tell exactly how much the gains are over the last three years because I was in and out riding the bumps. Later I add SWHC just in time for a 500% rise.

What brain was I using. The cold hearted calculating exploit human nature brain. Everybody knows solar and wind energy are vast improvements to oil and gas…until you have to pay for the energy. With guns, people are afraid of what’s coming. If the worst case scenario happens they want to protect what’s theirs.

Ron, thanks for you stories illustrating my point. They are interesting stories.

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Author

Michael Zhuang is principal of MZ Capital, a fee-only independent advisory firm based in Washington, DC. He is also a regular contributor to Morningstar Advisor and Physicians Practice. To explore a long-term wealth advisory relationship, schedule a discovery meeting (phone call) with him.



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