By Cameron O. Anderson

Investors and Advisors alike have come to accept the efficient market school theory that maintains that market activity is based on people making rational economic choices. But the reality is that people act on their emotions constantly and often unconsciously. We become overconfident or fearful, “irrationally exuberant” or regretful.  Our herd mentality often takes over while we perceive and frame our investing options in unusual ways.  But why? Neurofinance seeks to answer this question.

Neurofinance combines psychology, economics, and neuroscience, to study how people make investment decisions. The goals of neurofinance are to identify the psychological inputs that impact trading behavior and then connect these traits to trading success or failure. It also looks to develop the training methods to improve performance and lower risk.

There are certain behaviors that hold potential implications for investors. The following is an overview of common behaviors demonstrated by both investor and advisor:

  • Overconfidence and Hubris. Individuals generally assume they know more than they actually do. They also tend to remember previous financial decisions in ways that exaggerate their own foresight. This can lead to overly aggressive decisions and a reluctance to admit—and correct—mistakes. The “illusion of control” and “how great gains change the brain” are common themes explored in the field. Effective questioning techniques of investors and/or advisors help to uncover and correct this investment behavior.

  • Excitement, Greed and Irrational Exuberance. It is important to understand how these three motivators impact investment decisions. From Stock Spam Scams to Behavioral Investment Allocation Strategy (the BIAS model), we consciously or unconsciously deal with these drivers every day.

  • Regret. Regret over mistakes is a fact of life. Everything from buyer’s remorse to the “woulda, coulda, shouda” thing, are part of the inevitable mistakes we make. How to deal with and gain perspective on regret is a key success factor and can be examined logically if emotions are able to be put aside.
  • Mental Accounting. Advisors often advise investors to take their entire portfolio into account when making investment decisions. Yet, many investors unconsciously divide their wealth into separate pots. If they have a big gain, for example, they may think of it as essentially “free” money and take greater risks with it than they would with their “own” money. This can lead to inconsistencies in overall investment management and needs to be addressed explicitly in any investment plan.
  • Anchoring. Logically, decisions should always be based on current prices and expectations. Instead, they are often based on past events. For example, investors will become fixed on a past experience such as the price paid for a particular stock. Investors will often refuse to sell at a price lower than that—even when it makes more sense to accept their loss and invest their remaining money elsewhere.
  • Perception and Framing. How people view a decision often depends on how their choices are presented. For example, in one study researchers asked participants how much they would be willing to pay to avoid a one-in-a-thousand chance of being killed. The average answer was $1,000. Participants were then asked how much they would demand to accept the same risk. This time the amount ranged as high as $200,000. From an economic point of view, the two questions were identical, but subjects perceived and framed them very differently.
  • Group Think and “Herding” People typically tend to amplify the prevailing emotion by sharing a “group think” mentality when it comes to making business decisions. When this happens, the client tends to overreact. This phenomenon has been called the “illusion of effectiveness.” An individual’s need for “inclusion” and being “normal” is an important discovery area for investors and advisors.
  • Surprise. In financial markets, even a minor surprise can be upsetting and can lead to major changes, regardless of whether a sudden shift in strategy is really justified. It’s important to figure out how to limit the number of unexpected shocks and how to minimize the “sense of panic” when something unexpected happens.
  • Prediction. Generally people don’t like randomness. The human compulsion to make predictions about the unpredictable originates in the pleasure centre of the brain. This “prediction addiction” can be understood and managed if awareness of it is at a high enough level.
  • Fear, Risk and Loss Aversion. In a completely rational market, the risk of loss and the possibility of gain should carry equal weight, however in reality multiple studies have shown that many clients prefer to avoid the pain of having a bigger gain taken away to avoid feelings of inadequacy. Professional advisor often need to manage these client perceptions to implement the appropriate investment strategy.

  • Recency. Recency is the psychological tendency to overweigh the recent past when reviewing historical information. The effect can be devastating. For example, if a stock has been hot in recent months, more investors pile in. The collapse of the tech bubble in 2002 or the financial crisis of 2008 had an opposite effect. In September 2011 Warren Buffett invested $5B in Bank of America just before a major US government lawsuit against BOA was announced. What is the chance that Buffett will dump his stake based on short term considerations as the stock continues to fall?

The field of neurofinance is relatively new but it deserves our attention. We cannot ignore the human element that affects each decision that we make. When we understand how our emotions prompt buy and sell orders, we can better interpret our choices and avoid emotion-driven mistakes.

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