This is Your Brain on Money: Emotion Over Reason

Jul 29, 2009 Bruce Dzieza Posted in Articles

Calming Your Emotional Impulses and Economic Fears

Jason Zweig is a personal finance columnist for the Wall Street Journal and the author of Your Money and Your Brain: How the Science of Neuroeconomics Can Help Make You Rich. Mr. Zweig has researched a new discipline called neuroeconomics, which combines biology, psychology and economics to try and understand why investors often make emotionally-charged financial decisions. In Mr. Zweig’s research, he explores why emotion overrules reason for most investors and what makes investors confident that they can reliably predict the future.

What makes investors feel that they can predict the future?

Mr. Zweig asserts that unlike other animals, humans believe they are smart enough to forecast the future even when they know that it is unpredictable. An example of this has been demonstrated for decades by psychologists who have illustrated that rats stick well within the limits of their abilities to identify patterns, resulting in a natural humility in the face of random events. Humans, on the other hand, are a somewhat different story. In a typical experiment, researchers flash two lights - one green and one red. With the exact sequence being random, the green light flashes four out of five times and the red light comes on the other 20 percent of the time. In guessing which light will come next, the best strategy is simply to pick green every time, since there is an 80 percent chance of being right. And that’s what rats generally do when the experiments reward them for correctly guessing the color of the next flash. Humans, however, have different results. Instead of picking green all the time and locking in an 80 percent chance of being right, people quickly get caught up in the game of trying to call when the next red flash will come up. On average, this strategy leads people to pick the next flash accurately only 68 percent of the time. In a profound evolutionary paradox, it’s precisely the higher intelligence of humans that leads to the lower score on this kind of task. Mr. Zweig demonstrates that there are many parallels between this research and investor behavior. Many investors try to time when to get in and out of markets based on short-term news or forecasts, irrational emotions, or overconfidence in their ability to time the market. And even though a few of these market timers may be right once, they actually have to be right twice to get both into and out of the market at the right time. This pattern of being right twice will need to be repeated over and over for the market-timing investor to be successful over the long-term. If investors simply invest for the long-term in the first place (i.e. guess green on every flash) they have historically been rewarded as shown below.

  • The S&P 500 Stock Index has been up 59 out of 83 years or 71% of the time from 1926 - 2008 with an annualized compound return of 9.62%
  • A portfolio consisting of 60% S&P 500 and 40% Five-year U.S. Treasury Notes has been up 63 out of 83 years or 76% of the time from 1926 - 2008 with an annualized compound return of 8.48%

Source: Dimensional Fund Advisors (DFA) Returns 2.0

Why does emotion overrule reason for most investors?

Mr. Zweig states there’s a particular section of the brain called the amygdala which plays a primary role in processing emotional reactions (i.e. fear, anger, etc.). The amygdala kicks in with incredible speed and helps keep humans alive when confronting natural dangers such as a rattlesnake slithering across the path or a dog jumping to bite. However, when investors are confronted with volatile markets and/or negative news items from the media such immediate emotional impulses can lead to reactions that are not in their overall best interest. Most educated investors know what they are supposed to do: diversify, shut out the short-term noise of the market, rely on low-cost funds, and systematically rebalance portfolios without emotion when stock or bond markets make significant moves. They need to avoid the herd instead of becoming part of it. But do most investors do that? Mr. Zweig contends that most investors do not and when it comes to investing, most humans simply do not act rationally. The central finding in Mr. Zweig’s research is that the part of the brain that responds to emotions is not an optimal tool for making financial decisions. The part of the brain that tells investors to act rationally tends to be completely overtaken by much more powerful emotional impulses – impulses, Mr. Zweig observes, “that make us human.” Despite Mr. Zweig’s findings, he still remains an optimist because he thinks people can learn to resist their emotions and with a little effort focus on the rational basis of long-term investing.

So what do I do?

Zweig has also written a great article for Money Magazine entitled “8 Ways to Tame the Brain: The investing world is full of traps and our brains are wired to lead us into them.” Two of the suggestions are to:

  • Think twice
  • Use your words

Think twice -- “Making a financial decision while you’re inflamed by the prospects of a big gain – or a huge paper loss – is a terrible idea. Calm yourself down and reconsider only when the heat of the moment has passed.” Use your words -- The more complex cues of language activates the analytical areas of your brain. “To prevent your feelings from overwhelming the facts and leading you to sell in a panic, ask yourself:

  • Other than price, what’s changed?
  • Are my original reasons to invest still valid?
  • Shouldn’t I like this investment even more now that it’s cheaper?”