In the beginning, there was traditional economics, which insisted for years that our financial decisions are based on cold, calculated reasoning. We were taught that the choices human beings make—especially when it comes to the amount of risk or uncertainty we are willing to accept--are driven solely by rational consideration of what is in our individual self interest.

Then, in the 1960s, the hallowed halls of academia (not to mention central banks around the world) were rocked by psychologists Amos Tversky and Daniel Kahneman, who published a study contradicting the “rational man” of traditional economics. 

Tversky and Kahneman demonstrated that many, if not most, of the financial decisions we make are irrational, driven by our emotions. Their work became the basis of what is known today as behavioral economics.(1) 

Building on Tversky and Kahneman’s ground-breaking work, researchers are now taking behavioral economics even deeper, delving into the actual physical structures of our brains that trigger the emotions which affect our financial decision making. Researchers are observing what parts of the brain register increased activity in response to certain stimuli.

From an evolutionary standpoint, it ain’t exactly complimentary.

According to “neural economics,” our financial decisions are: 

1) largely driven by primitive parts of the human brain that we share in common with virtually all animals, including reptiles and

2) these brain centers can easily be manipulated by outside events and suggestions. Furthermore, they’re the reason most of us are either incredibly poor investors or, at best, mediocre ones.

Camelia Kuhnen, associate professor of finance at Northwestern University’s Kellogg School of Management, and other researchers have been focusing on two sections of the brain that affect emotions. She says the so-called “reward area” lights up when we perceive something positive.

“If you’re hungry and you see a piece of cake, or you look down and see $100 on the sidewalk.” As Kuhnen explains, the sight of a potential reward makes you approach the potential reward.(2)

On the other hand, the “anxiety area” becomes more active when we see something that is threatening or unpleasant: a bear off in the distance while you’re taking a walk in the woods. This triggers avoidance behavior, such as running back away. It’s the reason we tend to drive more cautiously after we pass an accident.

The brain’s reward and anxiety centers both trigger instinctive, self-preserving behavior--what we might call gut reactions.

These made sense for our Neanderthal ancestors whose survival depended upon being first to spot food or a dangerous predator.  But thousands of years later, these emotion-driven mechanisms are still firmly rooted in our brains and, unfortunately, make us lousy investors. 

“When the reward center is more active, people take on more financial risk,” says Kuhnen. “When the anxiety center is more active, they shy away from financial risk.”

This explains why, despite understanding on a rational level that the way to make money is to invest when prices are low and to sell when they go up, the average individual finds it excruciatingly difficult--if not impossible--to do so. Instead, we tend to irrationally buy high and sell low. And then wonder why our portfolios don’t have the same return as Warren Buffett’s.

Think back to the technology bubble of the late 1990s. First there was the “turn-of-the-century” scare when we worried that computer-controlled devices from microwave ovens to ATM machines to the power grid might shut down when the last two digits of the calendar year clicked to “00.”  Then there was the explosive growth of the Internet and nerdy college dropouts launching Web-based ideas without a shred of a business plan. 

By the time 1999 rolled around, if you didn’t own tech stocks, you felt like a nerd yourself.  Besides, wasn’t the “smart” money, i.e. the venture capital, chasing tech, too?  So, even though P/E ratios were literally off the charts, the “reward” center of your brain made you throw caution to the wind. 

You dove in. Late, of course. 

The same process was at work in parts of the country that saw the biggest gain- and subsequent collapse--in home prices.

In the wake of the subprime mortgage/derivatives meltdown of 2008, the average investor has been a wreck. For two years, disaster upon disaster struck the financial sector—landmark Wall Street firms going under, banks being taken over, government bailouts, steep declines in both the stock and bond markets and financial contagion spread globally.

“When people saw the [stock] market go down 30%, their anxiety centers became more active,” says Kuhnen. “It made them more risk-averse. They decided to take money out of the market and put it into savings accounts.” 

The trouble is, once either our “reward” or “anxiety” center is shocked by an unexpected event, we tend to think things will never change. In behavioral finance lingo, our expectations about the future become “anchored” to the present: “Real estate prices will continue to go up at double-digit rates.” “Stocks will never recover.” This makes us miss signs that conditions are changing. As a result, we wait too long to react.

That’s why ordinary investors began moving money back into stocks only in the past few months, we had to wait until our “reward” center noticed that prices had recovered substantially (thanks to those with the discipline to analyze, recognize and scoop up solid companies when their stocks prices hit bargain levels).

Not only do the emotional centers of our brain affect the way we invest, our risk tolerance can be artificially influenced. Without knowing the scientific basis, casino operators are pros at this. Think of what you experience at every Las Vegas venue: Lights!  Excitement!  Clanging bells announcing, 'New-Winner!'  Beautiful people! Free food and drinks! The moment you walk in, you feel as if money’s being given away right and left. It's what Kuhnen’s describes as “cues indicating potential rewards.”

The result is predictable: the reward center of your brain becomes more excited. When this occurs, people tend to take more risk. “They’re happy to gamble, go to the roulette table, or invest in high-risk assets.”

So, what advice does Kuhnen have for the rest of us? 

1. Invest in a diversified portfolio (3) Review it once a year to see if you should rebalance by considering whether you have too much in risky assets. This depends on such things as the number of children you have, an increase or decline in household income, your liquidity needs, etc.

2. Don’t look at your portfolio daily and make decisions about what’s going to happen tomorrow. “There’s not a lot of predictability in the market,” says Kuhnen.

3. “Don’t do any market-timing, such as taking all your money out. you tend to be wrong.” You leave when it’s too late and join when it’s too late.

Personally, I’d add:

4. Be honest with yourself. If you tend to let fear- or greed- influence your investment decisions, work with an experienced financial advisor who can be less emotional about your money.  Have a written plan that includes “what if” scenarios so that you know in advance what steps will be taken if market or personal circumstances change significantly.

If you still think you can overcome the reptilian part of our brain, good luck. The next time your spouse criticizes the lousy returns you’ve generated on your joint portfolio, don’t take it personally. Just explain that you simply can’t help it. Then flick your tongue and slither away. 

 

 

 

1. After Tversky’s death, Kahneman received the Nobel Prize for the work they did, but always maintained that the prize was shared.

2. You can read more about Kuhnen’s research here  

3. Kuhnen advocates index funds because their costs are low. You’ll at least get the average return with this approach.  Or, you can search out professionally-managed mutual funds that manage to provide above-average, long-term results at below-average cost. 

 

 

Ms. Buckner is a Retirement and Financial Planning Specialist at Franklin Templeton Investments. The views expressed in this article are only those of Ms. Buckner or the individual commentator identified therein, and are not necessarily the views of Franklin Templeton Investments, which has not reviewed, and is not responsible for, the content. 

If you have a question for Gail Buckner and the Your $ Matters column, send them to: yourmoneymatters@gmail.com, along with your name and phone number.