By Jason Zweig
Past returns are no guarantee of future success. Just like smokers ignoring the Surgeon General’s warning on the side of cigarette packs, investors overlook the most obvious caution about the stock market at their peril.
Even after Friday’s stumble over renewed fears about Europe, the Standard & Poor’s 500-stock index has gained 7% so far this year, and the Russell 2000 small-stock index is up 11%.
Why is it so hard for investors to regard such short-term hot streaks with the cold eye they deserve?
Decision Research, a nonprofit think tank in Eugene, Ore., has conducted a nationwide online survey of investors seven times since 2008. These surveys have shown that investors’ forecasts of future returns go up after the market has risen and down after it has fallen.
William Burns, an analyst at Decision Research, says investors’ forecasts of the market’s return over the coming year were heavily swayed by how stocks performed in the previous month.
They might not have had a choice. The investing mind comes with built-in machinery that sizes up the future based on a surprisingly short sample of the past. Neuroscientists say the human brain probably evolved this response in a simple environment in which the cues to basic payoffs like food and shelter changed slowly and rarely, making the latest signals most valuable—nothing like what today’s investors face with electronic markets in a constant state of flux.
Experiments led by neuroscientist Paul Glimcher of New York University found that cells deep in the brain calculate a sort of moving average of past events, giving the greatest weight to the most recent outcomes.
When the latest rewards turn out to be better than the long-term pattern, these neurons fire unusually quickly, spreading a burst of dopamine—the neurotransmitter that triggers the pursuit of reward—throughout the brain.
Thus, after a decade of mostly dismal stock returns, even a month or two of outperformance might prompt you into an impulsive plunge back toward stocks.
Some investors seem to have learned how to resist this tendency, and you should, too.
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