Magic, brain and stocks: A lesson in playing the cards right
A magician asks you to pick a card from a deck of playing cards, and not show it to anyone. Let’s say in this case the card you pick is the seven of diamonds. He then asks you to write down the name of five playing cards on a piece of paper. One of the five should be the card you picked and the other four should be random cards. Once you have that down the magician looks at the piece of paper for a while.
He then with unwavering confidence announces that the card you picked was “Seven of Diamonds”. Wait, how did he do that?
The magician goes on to explain how our handwriting often tends to differ when we are under some pressure. In this case we are trying to make sure that our handwriting is the same for all five cards, and under this pressure minute changes tend to occur. Enough practice and it makes for a pretty sweet card trick. He then goes on to tell you how many skilled magicians are often hired by some banks to help in detecting cheque fraud? Pretty cool right?
It is until you realize that all that was a bunch of baloney. Turns out that in most cases the magician is merely using sleight of hand and is forcing the card on you. He makes you pick the card he wants you to pick and the rest is mere acting and storytelling. (Forcing cards is one of the first things a card magician learns.)
A big reason why we instantly fall for the story a magician is telling us is due to our desire to listen to stories and find meaning in them. Being innately curious we are always looking to make sense of the world and in the case of magic, anything that makes some sense is adopted as a potential explanation.
Michael Gazzaniga, a professor of psychology at the University of California, Santa Barbara, had worked with patients who had undergone surgery to sever the corpus callosum. The corpus callosum connects the right and left hemispheres of the brain and so severing it does not allow the two halves of the brain to communicate with each other. Through his experiments with these patients, Gazzaniga concluded that the left hemisphere of our brain includes a special region that interprets the information we receive every moment and creates a story to explain that information. Gazzaniga calls this region the “interpreter”.
Unfortunately, the interpreter’s job is about trying to find any explanation of what it saw rather than fact checking and so it can often come up with nonsensical explanations. For instance, in the olden days, the area along the Nile River was known to be the epicentre for a lot of eye infections. As this was a common problem for the Egyptians they had to come up with a solution and one such solution was to drip bat blood into one’s eyes. The logic was that as bats can see during the night, they have sharp eyes and their blood had magical powers that will be transferred to humans. Just one example of the interpreter at work.
While we don’t drip our eyes in bat blood anymore, we still build stories and find illusionary relationships between two things, without testing them. This is a widespread problem, especially in the investing world. For instance, imagine that the price of a popular stock has suddenly dropped. You are now asking the same question that you do after seeing a cool magic trick. “How/Why did this happen?” Now instead of the lies of a magician, you are spammed with myriad explanations from various sources rationalizing this drop in price.
You switch on the television and you have a perpetual bear on the news channel, touching on global unrest impacting the price of the stock. You check the latest sell side coverage and notice a downgrade in the company’s outlook due to business uncertainty. You come across a technical analyst who is highlighting multiple charts showing a negative outlook for the company. You may even scroll through Twitter, and come across a few contrarians amongst the largely negative outlook.
Flooded with all this data from different sources your own interpereter is now at work. Remember that the interpreter’s job is to weave a possible story to explain an outcome and so all the data you just gave it is being used to weave a narrative. Crazy right?
Simply knowing all this we couldn’t help but think of four crucial learnings to improve our investing process.
- Garbage in Garbage Out – Our interpreter can only do as well as the data we give it and so if we are consuming a lot of garbage, it’s only natural that our interpreter may throw the same. The struggle that we as a generation are going to face is to be able to separate the signal from the ocean of noise.
- Circle of Competence – As we consume more data it becomes crucial to be able to distinguish between experts and pseudo experts. As Warren Buffett touches upon, playing the game in a sport we are already good at, is bound to be an advantage. Our interpreter will automatically be able to filter data better, if we are already an expert in the field. Also having models in our head to explain certain aspects of reality better, is bound to come in handy here.
- Randomness – As Nassim Taleb has often touched upon in the Incerto series, investing is a mixture of skill and randomness and so when we attempt to rationalize every move in the market, our interpreter is bound to occasionally confuse randomness with skill and come to faulty conclusions. After all, “I don’t know” is not something the interpreter is designed to say.
- Process Documentation – Knowing what data we are largely consuming, what our thoughts were after consuming that data and how our thoughts have evolved over time is almost a super power in itself. It helps us better refine our own investing process and not fall for hindsight bias.
So while the magician may still occasionally fool our interpreter, we can definitely try to train our interpreter to not make magic out of the stock market.
This article was first published on Economic Times. It is written by Dhruv Maniyar who is Assistant Manager (Research) at IIFL Asset Management as of February 2023.