Irrational Investing, Rational Marketing


What’s the difference between (1) investing in the common stock of a public company or (2) buying an expensive perfume or men’s fragrance? The answer seems simple… a financial investment is a decision based on a cold, rational analysis of the prospects for the firm and the expected increase in the value of the shares, while buying a fragrance is an emotion-laden decision based on marketing-driven images and subconscious brand associations. Actually, it turns out, that financial investment isn’t so rational after all.

An editorial in The Australian by Alan Wood, Bourse behaving badly? Crazy fortune favours the brain-damaged, reports on a JPMorgan paper on behavioral finance, citing some interesting research in pop neuroscience terms:

The reptilian brain is the most primitive and controls automatic functions such as breathing and heartbeat. The mammalian brain controls emotions, and the hominid brain, thought to have evolved later in human development, controls logic and higher-level thinking.

What happens in a situation where the mammalian (emotional) brain and the hominid (rational) brain are in conflict? Economists assume man is rational, but experiments suggest that in the case of a conflict it is the emotional brain that wins out. Other experts think the reptilian brain is involved with more than basic physiology and is an important factor in decision making.

A recent study examined decisions made by people with a healthy brain and those with lesions in their mammalian brain. The ones with injuries to their emotional brain made better financial decisions, suggesting the injuries impaired an emotional override of rational processes.

In one sense, we’ve always known that investment decisions aren’t completely rational. We have bubbles and panics, and the term “falling in love with a stock” has been used to describe investors who seem to be blind to a particular security’s poor prospects. Neuroscience, though, is starting to shed light on the details of this kind of behavior. Wood’s article notes that JPMorgan claims to use “behavioral finance” strategies in managing some of its mutual funds, claiming to earn superior returns “by capitalising on persistent market anomalies due to irrational behaviour by investors.” Behavioral finance is an interesting field that attempts to incorporate human behavior into financial analysis, and that is now being influenced by the more general field of neuroeconomics. On a closely related theme, in May we posted Irrational Decisions by Monkeys and Humans, which discussed how actual behavior in seeking rewards diverged from what traditional economics would predict.

Whether or not JPMorgan has unlocked the secret of capitalizing on irrational investment behavior, it’s clear that such behavior not only exists but is grounded in human brain structures and neurochemistry. (Based on the finding that individuals with specific types of brain lesions tended to make better financial decisions, one can imagine the recruiting process for a “behavioral” fund manager: “Chip, we’ve got good news for you… we’re offering you the position of fund manager for the new UltraRational Fund. There are just a few details to take care of. We have some agreements and waivers for you to sign, and you’ll need to report to our neurosurgeon for a brief and entirely painless procedure…” :))

The neuromarketing take-away from this is that if we humans make our most calculated financial decisions based on emotions and irrational criteria that we don’t perceive or understand, imagine the complex decision process for more nebulous products like autos, beer, clothing, etc. In particular, business-to-business marketers should pay attention to recent neuroeconomic research. We often think of business purchases of things like capital equipment, consulting services, office space, computer software, etc., as being coldly rational decisions based on the ROI of the expenditure. While certainly ROI is important (just as reasonable financial projections are important to an investor), it would be a mistake to neglect the reality that some portion of the decision will be based on emotional factors that the buyer may not acknowledge or even be aware of. The savvy B2B marketer will structure both her presentation and the deal itself to address issues like “risk to the buyer” that may be lurking a layer below the ROI numbers.

Leave A Reply

Your email address will not be published.