By Paul Gleeson BBS, QFA, CFP
This article also appears in the Celtic Connection, where Paul is a regular contributor.
What is the difference between somebody who is making money on their investments and somebody who is high on cocaine or morphine? Although these two activities couldn’t be further apart, the neural activity of two separate people doing both of these is virtually indistinguishable!
This is one of the many new findings that are emerging from neuroeconomic studies. Neuroeconomics may be new to many of us, but I believe it is something we need to pay attention to when it comes to our money. Understanding how the brain works won’t stop us feeling certain emotions, but it may help us keep these emotions under control when it comes to making financial decisions and instead base these decisions on sound financial reasoning.
Neuroeconomics is essentially a combination of neuroscience, psychology and economics. Intuitively, many of us understand how human emotions affect our investment decisions – that fear and greed can influence decision-making and that these emotions, amongst others, can have very damaging effects on our long-term wealth accumulation efforts.
Neuroeconomics goes a step further and looks at the actual brain function and the mechanics of what is going on in our brain around financial decisions, risks and outcomes. I am currently reading a fascinating book on this subject called “Your Money & Your Brain” by Jason Zweig, so I want to share some of the findings highlighted in his book with you.
Personally, I am a big believer in listening to your gut when it comes to decision-making. When it comes to making investment decisions, however, relying on your gut can be a very dangerous proposition. Also consider this: the way your brain actually functions may be working against you when it comes to your financial and investment decisions.
In order to understand brain function, instinct, and finance, let’s look at a common investment situation. You buy a stock on the Toronto Stock Exchange. The price of the stock goes up on successive days and you are quite happy with yourself. Then the price comes down and continues to fall. Panic sets in, so you decide to cut your losses and sell the stock.
Obviously, you have lost money on this investment. It is simple to say our emotions got the better of us; we got scared when we saw the price coming down and that’s why we sold out of the investment. However, that’s not the full story.
Here’s an interesting fact from Zweig’s research – “After two repetitions of a stimulus – like say, a stock price that goes up twice in a row, the human brain automatically, unconsciously and uncontrollably expects a third repetition.” So in our example above, our brain was wired to expect the stock price to continue to rise.
Another fact from Zweig’s research – “financial losses are processed in the same area of the brain that responds to mortal danger.” Basically, the area of the brain designed for survival should our lives be at risk is the same part of the brain that processes a financial loss.
In the context of the above example, our brain was, in essence, wired to sell out of this investment as the stock price fell when (on paper at least) we were losing money. In this financial situation, the brain’s natural function and stimulus worked against us!
While I’m not a neuroscience expert, I did recently have the pleasure of seeing a brain expert (Terry Small) speak at an event here in Vancouver and I absolutely believe that the fascinating insights he shared, along with advancements in neuroscience explained in Zweig’s book, have a huge place in our financial decision making.
Based on the brain’s trigger to feel “mortal danger” at the sign of financial loss and sell investments out of instinct, it would appear that, as human beings, we are naturally wired to lose money. When we see a positive financial result, our inclination is to anticipate more, and when we see a negative result, our brain patterns dictate that we must “survive” by ridding ourselves of that which is causing the pain (ie the volatile investment).
We are in the midst of a volatile investment climate which could remain with us for several years. I have no doubt that a greater understanding of how we make financial decisions (from both an emotional and a physiological perspective) will enable all of us to make better decisions in the months and years to come. Over a long period of time, I suspect this may have a profoundly positive effect on our wealth accumulation efforts.
A significant way to combat our wiring is to have a carefully thought out financial plan and investment strategy in place. In particular, an investment strategy that can reduce portfolio volatility will be an enormous help. There are many ways to do this and next month I will explore some ideas on how to overcome this emotional factor and share some strategies that I use with my clients to help them become successful investors.
What experience have you had with fighting your financial wiring? Let us know in the comments below!