The human mind may be well suited to surviving in dangerous forests and plains, but it doesn’t do as well with modern financial decisions. A lengthy and interesting article in Money by Jason Zweig (read it online at CNNMoney.com – Your money and your brain.) highlights some of the areas where our brain’s decision-making processes yield results that are often less than optimal from an economic standpoint. He describes a variety of current neuroeconomics research to make his points, and even was put in an fMRI machine to take part in an experiment run by Brian Knutson of Stanford University. In short, our brains evolved to avoid risk and seek rewards, but don’t do a great job of balancing those in financial decisions. Zweig thinks better understanding of our neurological shortcomings will make us better investors:
Your brain developed to improve our species’ odds of survival. You, like every other human, are wired to crave what looks rewarding and shun what seems risky.
To counteract these impulses, your brain has only a thin veneer of modern, analytical circuits that are often no match for the power of the ancient parts of your mind. And when you win, lose or risk money, you stir up some profound emotions, including hope, surprise, regret and the two we’ll examine here: greed and fear.
Understanding how those feelings – as a matter of biology – affect your decision-making will enable you to see as never before what makes you tick, and how you can improve, as an investor.
One key thread in Zweig’s article is the importance of reward anticipation. Anticipating a reward, which might also be pejoratively termed “greed,” produces higher levels of brain activation than actually getting that reward. Anticipating a big reward is particularly potent. This is why lottery ticket sales boom when the jackpot hits, say, $100 million or more. The thought of the huge prizes triggers the reward anticipation effect, and people flock to buy tickets even though their odds of winning are infinitesimal. Looking at more conventional investments, the potential of a big reward is what causes investors to invest in hot biotech stocks even when the firms have little revenue and uncertain prospects.
Fear is another emotion that doesn’t work well in financial decision-making. Zweig points out that our evolved brains do a poor job overall with fear – we worry more about nuclear reactors than sunlight, and more about rattlesnakes than deer. In fact, sunlight kills far more people every year (via skin cancer) than nuclear reactors, and deer are much more deadly to humans (from auto crashes) than snakes or scary predators. Financially, we worry more about a stock market collapse (unlikely – there’s only a 2% probability of a 33%+ drop in a given year) than inflationary erosion of our portfolio’s value (much more probable).
There’s a lot of information in this article – I highly recommend it. Some of the neuroeconomics points made by Zweig have neuromarketing implications as well, and I’ll highlight one or two in a future post.