Sometimes investing just makes you want to whack your head against the nearest wall over and over again. The funny thing is, doing that might actually improve your long-term returns.
There's nothing amusing about brain damage, but according to new research out of California Institute of Technology, New York University, and the University of Iowa, people with damage to the frontopolar cortex may be in a better position to be good long-term investors. Tack-sharp Wall Street Journal columnist Jason Zweig wrote about the research over the weekend and described the frontopolar cortex as an area "directly behind your forehead ... Much larger in humans than in other primates, this area is critical to such advanced mental functions as memory, exploring new environments and making decisions about the future."
The study didn't directly involve investing, but instead used slot machines, pitting the frontopolar-impaired group up against a group of patients that had suffered brain damage, but not to the frontopolar region, and a perfectly healthy group. Just like a day in Las Vegas, participants were invited to play any of four slot machines as they chased the best payoff. The machines were programmed to pay out randomly.
Here's where it gets interesting. The two groups without frontopolar impairment both tended to go after the machines that had most recently given a good payout. When it appeared as if one machine had gone cold, they'd hop to the next one. In other words, they were desperately seeking a pattern among the random payouts.
Those with damage to the frontopolar cortex, on the other hand, made choices based on the overall experience of payouts rather than trying to put together a pattern from the most recent hits. As Zweig put it: "Without the ability to tap into one of the brain's most advanced reasoning centers, these people didn't try to outsmart the system or to guess the next outcome of an essentially random process."
Skip the nuclear option
Zweig doesn't seem to think that my suggestion in the headline above is the best way to go. He writes: "The solution to short-term thinking isn't to bash yourself in the forehead with a hammer, of course. But you can use your brainpower to your advantage." Sage advice.
Keeping the research in mind, what we don't want to do, then, is get sucked in to trying to detect patterns that just aren't there. Warning signs that you're doing this include using phrases like "due for a bounce" or "it's trending." Drawing actual patterns on stock charts is also a pretty good sign that your frontopolar cortex is hard at work creating illusions. A lot of this sort of ill-advised activity falls under the header of "technical analysis" and longtime Fool readers will no doubt know that we're not big fans -- in fact, a couple of years ago, my fellow Fool Anand Chokkavelu wrote bluntly that "technical analysis is stupid."
On the other hand, using your brainpower to your advantage, as Zweig suggests, involves looking at the bigger picture. That is, considering stocks not as blips on a screen that are plotting out some mysterious mathematically traceable pattern, but what they actually are -- ownership stakes in real companies. As such, buying them isn't an exercise in quick trades and strange terms like "Aroon oscillator," but, instead, a careful study of businesses, the products they offer, and the people that manage them. Buying and selling becomes a question of whether the market price is over or under a reasonably estimated value for the business.
It ain't dead, folks
Zweig notes that those focused on short-term movements like to toss around the idea that "buy and hold" investing is dead:
But if "buy and hold is dead," as growing numbers of investors argue, it isn't clear what else is alive. ... Most of the folks who say buy and hold is dead don't talk much about their long-term returns. Instead, they stress how they have done recently, a tactic that for many potential clients has the same irresistible appeal as the last couple of pulls on a slot machine.
Buy-and-hold is not dead. It's just been badly misunderstood. Despite being very successful businesses, Cisco (Nasdaq: CSCO ) and EMC (NYSE: EMC ) have lost 70% and 55%, respectively since 2000. That's not because buy-and-hold doesn't work. It's because buying stocks with a price-to-earnings multiple above 100 (Cisco's was 180) generally doesn't work. With respective multiples of 12 and 22 today, the companies are much more palatable investment considerations.
There were also stocks that performed splendidly as buy-and-hold investments over that same period. Precision Castparts (NYSE: PCP ) returned nearly 2,400%, while Ross Stores (Nasdaq: ROST ) gave investors almost 1,400%. At the beginning of 2000, Precision traded at 6.4 times its earnings, while Ross was at less than 11 times its earnings. And while they have huge trailing returns on their scorecards -- which would likely make the frontopolar cortex light up like a Christmas tree -- these aren't the same slam dunks today as they now trade at earnings multiples closer to 20.
This is not, of course, to say that when you invest this way every investment decision you make will pay off. It won't. It doesn't matter if you're Joe Schmoe or Peter Lynch, you're going to get it wrong sometimes. But a good starting place for getting it right more often than you get it wrong -- or at least, not having it all happen at random -- is understanding how your brain works and in what ways it's preprogrammed to lead you astray.
If you're ready to bypass the quirks of your frontopolar cortex and focus on stock analysis that's not based on nonexistent patterns, The Motley Fool's investment team has picked out three great stocks to start with. U.S.-based but with solid products and operations that are set to dominate globally, these three companies need to be on your radar. To find out which stocks we're talking about, grab a free copy of the Fool's special report: "3 American Companies Set to Dominate the World."