It’s a well-known belief that you should never rely on your emotions, your “gut feelings,” when making investment decisions. If you “feel good” about a stock, that isn’t enough to ensure it will be a profitable piece of your portfolio. But does scientific research back up that belief? Absolutely.
Neuroeconomics is an emerging branch of science that tracks how the human brain makes decisions about the financial world – how we calculate risk and return and how we react to making or losing money. What researchers have discovered is that emotions and the way they affect our decisions play an important role in developing good investment strategies.
“The human brain is really all about emotion,” said Jason Zweig, author of Your Money and Your Mind and columnist for The Wall Street Journal . “If we don’t understand how emotion is generated in the brain, we would conclude that investing is all about rational decisions and making sure that what we do makes perfect sense. But you don’t have to have been an investor very long to know that’s not really the way the world works. That’s because it’s not how the human mind works. Investing is a profoundly emotional experience.”
For example, when Zweig had an MRI performed on his brain when he was anticipating making money from an investment, the emotional core of his brain lit up like a Christmas tree, while the cortex — which controls rational thought processes – remained uninvolved. After the investment came through and a profit was made, the MRI showed that Zweig’s cortex kicked into gear, analyzing the trade and processing the information. During this period, his emotional core was uninvolved.
In layman’s terms, what does this mean?
“The lesson is that expecting to make money often feels better – more intense, hotter to your emotional brain – than experiencing a profit turns out to be,” Zweig says. “This is often what drives people to take excessive risk when they are confronted with the hope of a large future gain. They think that when they get it, it will feel better than it actually does.”
“Expecting to make money often feels better – more intense, hotter to your emotional brain – than experiencing a profit turns out to be.” — Jason Zweig
While the rush of anticipation can fool us into taking excessive risk, fear can also keep us from taking the risks we need to. When something scares you financially, a section of your brain called the amygdala registers that fear in less time than it takes to blink, sending your pulse soaring and raising your blood pressure. Fear tenses your muscles and causes the release of stress hormones into the bloodstream.
“In the presence of fear, you will push more than you will pull and you are hypersensitive to loss,” Zweig says. “It becomes harder to think of unusual options, and you become much more conservative. When we are afraid, we are much less trusting and will see patterns that aren’t there in random data. You will be literally trigger-happy – primed for negative information and for selling. That’s what fear does to you.
“In the moment where you are afraid, your decisions will be utterly different than how you will decide when you are not afraid.”
If we know that emotions “fool” us into making the wrong investment decisions, how can we downplay them? Here is Zweig’s advice:
1. Reframe. In other words, if a broker is telling you that he can give you a 90 percent guarantee that you will make a 10 percent return with no risk, tell yourself there is therefore a 10 percent chance that you will not make that return. If the stock market is telling you about your losses (kicking fear into play), you can remind yourself about your past and current gains.
2. “Neuter” your information. If you are considering buying stock in several companies and you are going to read their balance sheets, have someone black out every place where the company name is written. That way, you will strictly be looking at the numbers, not the way you feel about a particular company.
3. Track your feelings. “Look back in time. See how you felt, when, and about what,” Zweig says. “When the market went up, did you feel good because you were making money? Or did you feel bad like Warren Buffett because you knew the deals were disappearing?”
The bottom line? You can’t turn your emotions off, but you can turn them inside-out. The way you feel isn’t the best barometer for making wise investment decisions.