Economics

Neurofinance: Inside the investor's brain

At the annual Schroders Investor Conference in Budapest, delegates heard from ‘neurofinancier’ Dr. Richard Peterson, who outlined how deceived we can be by the apparent rationality of our own minds.

09/10/2015

Dr. Richard Peterson

Chief Executive, MarketPsych LLC

Irrational thinking

Our brains like to take short cuts, and this can have serious ramifications for investment success or failure, according to behavioural economist and psychiatrist Dr Richard Peterson.

Dr. Peterson is Chief Executive Officer of Marketpsych, a psychology-based big data provider to asset managers.

Certain subconscious shortcuts that our brains take can be particularly insidious when making investment decisions.

Research has shown that humans are far less rational than standard economic theory assumes.

The good news, says Dr. Peterson, is that much of this irrationality is systematic, and because it is repeated, it can be predicted and possibly even prevented.

Dr. Peterson discussed the dangers of ‘emotional priming’ as just one example of how we can fall prey to our brain’s shortcuts.

Emotional priming can have a material impact on our propensity to accept risk, and what’s more, we are unlikely to be aware it is even happening.

Investment experiment

In a 2007 investment experiment, a group of subjects was shown either a happy, fearful or angry photo of a human face.

The subjects shown the happy face were found afterwards to increase their tolerance for risk by as much as 30%, versus the other subjects.

What’s more, the experiment’s participants denied that the faces they saw had affected their judgement at all.

The problem is that our prefrontal cortex, which governs judgement and executive functions, evolved on top of our deeper limbic system, which governs emotional responses.

The result is that our brains can actually override rationality. This results in some interesting patterns, which Dr. Peterson follows through the Thomson Reuters MarketPsych Indices.

Statistically, he says, September is the ‘angriest’ month of the year, whilst December is the most optimistic.

Given our demonstrable susceptibility to our surroundings in forming decisions, it follows that certain emotional qualities often make for better investors.

Emotional stability and openness are prime examples of personality traits that can be shown to have a positive impact on returns.

Defending your logic

The question is, if an investor is armed with this knowledge, is it possible to overcome these emotional biases? The answer from some of the world’s most successful investors is: yes.

According to Warren Buffett, intellect need have nothing to do with performance, but emotional discipline is essential.

“Success in investing doesn't correlate with I.Q. once you're above the level of 25,” Warren Buffett has been quoted as saying.

“Once you have ordinary intelligence, what you need is the temperament to control the urges that get other people into trouble in investing.”

The temptation when investors are presented with a decision is to seek out more information. What the aim should be, says Dr. Peterson, is to seek out better information.

Investors should try to filter out inputs or people that are not adding anything valuable.

He recommends a two-step process to investment decision making, in which investors first manage stress before taking action.

If investors are concerned about markets, they ought to assess the present cause of their worries in the context of the wider market influences.

Having done so, it is best to then to mitigate the anxiety-provoking stimulus before taking action.

Ultimately, the recognition of our irrationality is the most important step in overcoming it. Picking the right stock, bond or fund as a part of a balanced portfolio is still a tremendous challenge.

However, once we are aware that our brains are susceptible to potentially damaging emotional patterns, we can better defend more logical responses

Important information: The views and opinions contained herein are those of the named author(s) on this page, and may not necessarily represent views expressed or reflected in other Schroders communications, strategies or funds. This document is intended to be for information purposes only and it is not intended as promotional material in any respect. The material is not intended as an offer or solicitation for the purchase or sale of any financial instrument. The material is not intended to provide, and should not be relied on for, accounting, legal or tax advice, or investment recommendations. Information herein is believed to be reliable but Schroder Investment Management Ltd (Schroders) does not warrant its completeness or accuracy. The data has been sourced by Schroders and should be independently verified before further publication or use. No responsibility can be accepted for error of fact or opinion. This does not exclude or restrict any duty or liability that Schroders has to its customers under the Financial Services and Markets Act 2000 (as amended from time to time) or any other regulatory system. Reliance should not be placed on the views and information in the document when taking individual investment and/or strategic decisions. Past Performance is not a guide to future performance. The value of investments and the income from them may go down as well as up and investors may not get back the amounts originally invested.  Exchange rate changes may cause the value of any overseas investments to rise or fall. Any sectors, securities, regions or countries shown above are for illustrative purposes only and are not to be considered a recommendation to buy or sell. The forecasts included should not be relied upon, are not guaranteed and are provided only as at the date of issue. Our forecasts are based on our own assumptions which may change. Forecasts and assumptions may be affected by external economic or other factors. Issued by Schroder Unit Trusts Limited, 31 Gresham Street, London, EC2V 7QA. Registered Number 4191730 England. Authorised and regulated by the Financial Conduct Authority.