Tip Sheet from the Neuroscience of Investing
Making good financial decisions is difficult for most people. We all have hopes and fears regarding our investments, yet unknown to us, these same hopes and fears can damage our investment performance. A moderate level of emotionality is necessary for balanced reasoning, but peaks of hope (a.k.a. greed) and fear have destructive potential. Ignorance of our financial emotions can be very costly over time.
Neuroscience research demonstrates how these emotions originate in the brain's center of emotional processing, the limbic system, in various financial situations. We can learn to identify these emotional disturbances in our financial reasoning. Distorted reasoning is often characterized by intense feeling. However, unless we make a conscious effort to become aware of our feelings, we can easily succumb to their destructive tendencies.
Often, when considering potential gains, our reasoning is distorted by high levels of excitement, hope, and greed. When thinking about potential losses, our reasoning is distorted by high levels of worry, fear, and recent pain. As greed dominates our thought process, we're likely to take on more risk than anticipated. When experiencing strong greed, we often excitedly rush into investments. As fear dominates our reasoning, we're likely to take on less risk than optimal. When fear is at an extreme, we may attempt to gain relief through the panicked selling of painful ("bleeding") positions.
Our level of greed is increased when one or more of the following conditions is met:
- Recent positive price performance of a security one is considering purchasing.
- Comparison with others who are successful with this investment (often anecdotal).
- Learning of a large potential payoff.
- Learning of a high probability ("almost certain") payoff.
- Expecting a quick payoff.
- Liking a company or its products.
- Having a glamorous association with a company or its products.
- Wanting badly to make money from the investment.
- Having a positive prior experience with similar investments.
Our level of fear is increased when one or more of the following conditions is met:
- Recent negative price performance of a security one owns.
- Increasing negative information flow or media coverage (even if it is redundant).
- The possibility of a dramatic negative event (E.g., bankruptcy, accounting scandal, earnings disappointment, or executive defection).
- Low probability threats are overweighted if they are dramatic or potentially catastrophic.
- Expecting to lose soon.
- Disliking the company or its products.
- Having negative associations with the investment.
- Wanting badly to avoid losing money in the investment.
- Having a prior negative experience with similar investments.
Several personality characteristics are associated with greater experiences of greed or fear. In general the personality trait extraversion is associated with gregariousness, optimism, and exuberance. The personality trait neuroticism is associated with pessimism, anxiety, and irritability.
- Extraverts are more susceptible to taking excessive risk ("greed" and overconfidence)
- Neurotics are more likely to irrationally avoid risk (sensitive to "fear")
Use the following to gauge your own level of emotionality when making investment decisions. Are any of these present? In a high-emotion state (either greed or fear), we are more likely to:
- Check prices of our investments more frequently than usual.
- Follow our emotional reasoning over logic.
- Impulsively jump into and out of investments: overtrading.
Investing errors caused by Greed and Fear are magnified by uncertainty, inexperience, and disorganization. These errors are more common when we:
- Are uncertain about the significance of market or investment-related information.
- Are inexperienced with the current market environment or investment type.
- Have an untested, disorganized, or incomplete investment plan.