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The Ponzi-Limbic Connection



John's Ponzi article above is masterful insofar as it captures the broad range of emotions that people experience when they are guided by their limbic systems in making financial decisions. We have written obliquely in the past about the limbic system - that portion of your brain that controls emotions (fear, greed, envy, etc.) - and its important role in behavioral economics.

In fact, as the fascinating and emerging field of behavioral economics is finding out, most financial decisions are made by the limbic system rather than with the more rational cerebral cortex. This is why, for example, most investors, despite knowing that buying low and selling high is the correct (rational) thing to do, actually do the opposite. They buy high and sell low. The history of finance, with its bubbles, manias, and parabolic price movements (see the chart of silver for the latest good parabolic example), is replete with the evidence of this statement. People follow the crowd: and if the crowd is buying, they buy too. Logic be damned.

It might surprise you to know that this behavior is actually a survival instinct. Indeed, for most of human evolution, this herding instinct has served an important function. In a world of limited information, the assumption that a group has a better sense of where food, fuel, or shelter can be found than does a single individual makes sense. If the rest of the Cro-Magnons are heading south in search of food, the probability that they are right and you are wrong is high. Heading north might get you killed. So this type of hearding behavior had an important evolutionary role.

But like the appendix, it can be argued that this herding instinct is mostly a liability now. After all, buying high and selling low will eventually lead to financial ruin, which could seriously impair your ability to buy food or shelter. But I digress; my point is that recognition that the limbic system plays an important role in most (if not all) investors' decisions is key to understanding the markets. It just so happens to be key to understanding ourselves as well.

ps - Happy 3rd birthday Jackson! May God bless you with many more years.

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