Neurofinance: Inside the investor's brain
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.
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
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