Dreaming of Alpha

"Sleep is the interest we have to pay on the capital which is called in at death; and the higher the rate of interest and the more regularly it is paid, the further the date of redemption is postponed."
-Arthur Schopenhauer, 18th Century Philosopher

Investment decisions reflect the strategy, research, process and discipline consciously developed over many years. They also reflect influences from the unconscious brain that, for the most part, are not taken into account... even sleep. Sleep deprivation is epidemic in America. Among stressed-out portfolio managers, sleep seems to be a rare asset. Beyond making you feel drowsy or in need of caffeine, new research shows that inadequate sleep heightens behavioral responses, inhibits learning and weakens decision making. This essay looks at the facts about "running on empty" and how it can undermine your performance.

Huh, yeah, right...

Everyone knows what its like to be sleep deprived. Depending on how many hours are lost, and for how many consecutive nights, symptoms may range from a slightly wandering focus to full stupor. These commonly observed effects are easily reversed with extra sleep.

Yet even these transient effects can negatively impact investment decisions. Sleep deprivation can lead to stress, a subject we examined in a previous essay. Stress shifts the thought process, weakening analytic thinking and promoting emotional reactions. Higher emotional states enable behavioral forces to influence investment decisions. Behavioral motivations, in turn, push decisions outside of your strategy and process, often negatively impacting return and alpha.

I must have missed that...

Critically important, inadequate sleep hampers learning. Not just memory, but the ability to extract explicit knowledge and insights from new information. Our short-term memory loses its current content before the information is synthesized with what we already know.

New research from Harvard Medical School further explains this process. The Harvard study shows that a loss of sleep adversely affects the functioning of the hippocampus, which plays a central role in the sorting and storing of information in the brain. In describing the affect of sleep deprivation on learning, based on research conducted using Functional Magnetic Resonance Imaging (FMRI), Harvard’s Dr. Matthew Walker says "...the impairment comes from impaired brain functioning — almost as if a temporary lesion had formed on the hippocampus rather than reduced alertness or the inability to take in the information." In other words learning is not reduced merely because we have less energy or focus, but largely because our brain is unable to process and store what we think we learned.

It felt right at the time...

The amygdala is the part of the brain that helps manage emotions. It is particularly important in providing context and enabling us to effectively deal with negative or adverse stimuli. The Prefrontal Cortex controls logical or analytic thinking. Brain research informs us that sleep deprivation can deliver a powerful 1-2 punch that undermines our ability to make disciplined decisions. Inadequate sleep causes the Prefrontal Cortex to shut down, leaving only the emotional portion of the brain available for decision-making. Now add the fact that sleep deprivation also challenges the functioning of the amygdala. What's left is a brain that is incapable of logical or analytic thinking and which is likely to over-react to adverse stimuli.

In another FMRI study, Dr. Walker observed that "The emotional centers of people sleep deprived were 60% more active than those with normal sleep." This result argues that their decision making would reflect heightened emotional responses, all of which suggest that — just like professional athletes — professional investors will perform better when they come to the game with enough sleep.

Before you doze off...

Being your best means attending to the small as well as large challenges you face. Lack of sleep impairs decision making. It curtails analytic thinking, heightens emotional reactions and diminishes the ability to learn. Not the sort of mental prowess showcased in the average "pitch book."

So how much sleep do we need? According to Christopher Drake, a senior scientist with the Henry Ford Sleep Disorders and Research Center, "The human body needs approximately seven to eight hours of sleep a night to maintain optimal alert levels during the day. The idea that many people need just four or five hours of sleep a night is a myth.", he says.

A small seemingly benign aspect of modern life, sleep deprivation can steal alpha from your portfolio. Its effects include substantially increasing the likelihood of behavioral forces impacting buy/sell decisions. This exposure is greatest where process and discipline are fragile — typically selling. That leads us to suggesting a new investment performance enhancer: Alpha Naps.

References:
1. "Sleep inspires insight", Nature, January 22, 2004; By Ullrich Wagner, Steffen Gais, Hilde Haider, Rolf Verleger & Jan Born.
2. "Learning to Live Like an Early Bird", The Wallstreet Journal, March 4, 2008, by Melinda Beck.
3. "A deficit in the ability to form new human memories without sleep", Nature Neuroscience, published on-line, February 11, 2007, by Matthew Walker, Peter Hu, Ninad Gujar and Seung-Schik Yoo.
4. "The human emotional brain without sleep: a prefrontal amygdala disconnect", Current Biology, October 23, 2007, by Seung-Schik Yoo, Ninad Gujar, Peter Hu, Ferenc A. Jolesz and Matthew P. Walker.
5. "Stressing Performance", Behavioral Matters, essay from Cabot Research LLC, December 8, 2008.