Four Keys to Profiting from Mean Markets

1. Be Different

A key to making money is to buy when others are selling and sell when others are buying. In other words, in order to make money we have to do the unpopular behavior that others arent doing.

Running against the mob is difficult because we are built to want to do what others are doing-we want to be part of the group. One study found that social isolation creates pain. In the study, three people played a ball-tossing game on a computer screen while one sits inside a brain scanner. The person in the brain scanner is told that the two other players are real people, but they are actually fake people controlled by the experimenter.

The experiment looked at the brain in two conditions, being part of the group or being ostracized. In the first, the real person is part of the game and gets the virtual ball frequently. In the second, the two artificial players exclude the real person by passing the ball back and forth.

Social isolation produced pain in these people. In fact, the brain scan revealed the same electrical pattern as physical pain.6 So when we act differently from others we have to overcome our human desire to be part of the group.

This same study showed another interesting pattern. Those people who employed their cognitive abilities more, felt less pain. To be precise, the people who had higher levels of brain activation in the prefrontal cortex had lower levels of activation in the pain centers. As is one of the main themes of this book, success requires using cognition to control the lizard brain.

2. Make the Investment Moves That Do Not Produce Dopamine

Another key to making money is buying investments that have not done well and selling those that have done well. As humans, we still share the do-it-again brain centers with other animals. As B.F. Skinner made famous, animals, including humans, tend to repeat behaviors that were

rewarded. Thus, Skinners stimulus-response system leads us to love the investments that have made us money and hate the investments that have lost us money.

Our brains are actually bathed in pleasure-causing dopamine when we take the actions that have worked before. Spencer Johnson and Kenneth Blanchard captured the essence of this in their bestseller Who Moved My Cheese? In a world without change, the best way to find cheese is to return to the location where it was found previously. In a world with change, however, the best way to find cheese is to look somewhere new.

Financial markets are the worst environments in which to use stimulus-response processes. Precisely because most people fall in love with past winners, they tend to buy the investments that have gone up, not the ones that will go up. Thus, to make the correct financial decisions, we need to do exactly the opposite of what has been giving us our emotional reward. To make money, we need to break the dopamine addiction (at least in this area of our lives), and use our cognitive ability to control our behavior.

Those who want to follow the Mean Markets and Lizard Brains advice to reduce financial risk will have to do precisely the opposite of what has worked well for a generation.

3. Make an Emotionally Realistic Financial Plan

A third key to making money is to understand our own limits and to make a financial plan that we can execute.

In Platos Apology of Socrates, the oracle of Delphi says that Socrates is the wisest of men. Socrates is aware of his own flaws and so asks, How can this be? After a conversation with a man widely deemed to be brilliant, Socrates concludes, I do not suppose that either of us knows anything really beautiful and good, I am better off than he is, for he knows nothing, and thinks that he knows; I neither know nor think that I know.

Socrates is the wisest of men, Plato suggests, precisely because he is aware of his flaws. Similarly, successful investors must be aware of their own irrationality.

In some unusual circumstances, people sometimes execute the perfect financial plan. For example, in 1987, a Massachusetts man (who wishes to remain anonymous) bought 1,000 shares of EMC for $15.75 a share. He held on to the shares for 13 years, by which time they had become 48,000 shares (because of splits) each worth more than $100.00.7

For 13 years, this investor patiently rode his profits and converted $16,000 into almost $5 million. In contrast, most investors make the mistake of harvesting their profits too quickly and riding their losses.

Even great investors tend to sell their winners too soon and to never sell their losers. In the 1940 investment classic Where are the Customers Yachts? Fred Schwed, Jr. writes, When a great and sagacious financier dies, and the executors go through the strongbox, they usually find, tucked well away in the back, bundles of the most hopeless securities whose very names have been long since forgotten. 8

So how did our EMC holder resist the temptation to take profits? He simply forgot that he owned the stock! He originally bought 3,000 shares and sold 2,000. He didnt know that he owned any shares until he was notified by a state agency about his inactivity.

Unless we can similarly forget about our investments, we have to anticipate our weaknesses. A frequent problem is that an investor has a perfect plan, but then makes an emotional trade at precisely the wrong time. Thus, in my low-risk financial plan, I keep enough money invested in stocks to stave off the lizard brain. Each person has to craft a customized financial plan that anticipates and preempts moments of irrationality.

4. Be Tough Enough to Stick to a Plan

When I was in middle school, my friend Paul ran the 600-yard run (the longest event) in the schools annual athletic competition. Opposing him was Jimmy, one of the bullies and part of the in-crowd. My friends and I desperately wanted Paul to win, and we gathered round him minutes before the start.

Paul knew that the race had implications for all his friends and for the schools entire social order. He spoke to us in a serious and calm manner.