The brain is a fascinating organ. Especially when it’s dealing with the world of investment. What’s going on inside your mind when faced with the ups and downs of the market? How does this affect the way you feel? And more importantly, what can you do about it?
For a long time, economists have thought of investors as rational people, capable of dispassionate and optimal investment decisions. It is only in the second half of the 20th century that some researchers really started challenging the human ability to be consistently rational, especially when investing. This led to the emergence of a very prolific field of research: behavioural economics. Several hundreds of articles and a few Nobel prizes later, nobody would dare to question that emotions and psychology play a key role in an investor’s choices. But which emotions come to play? Recent advances in the field of neuroscience* have revealed fascinating clues. Let us take a tour through your investor brain, see emotions at work, and understand how we can deal with them.
The point is not to try and suppress emotions…but more to acknowledge when they kick in…
Any resemblance to actual persons or events is purely coincidental. Or not.
Let’s use a fictional story to set the scene.
Imagine yourself enjoying a cup of hot coffee with one of your best friends. This friend is never short of good ideas and always seems to be on top of everything happening in the world. At some point, your friend asks, “Have you heard about this new company? They’re about to launch a new, revolutionary product. And I know the manager. Believe me, it will make a killing and the stock will fly. I already bought 1,000 shares and made 200% on my investment. And it’s only the beginning. You should invest too!” This got you thinking. On your way back home, you nervously browse the web for more information about this mysterious company. Your body and mind are fully absorbed in this quest. Once you arrive home, you jump on your trading account to buy some shares too. Pushing the buy button procures you an indescribable cocktail of emotions. How intense investing can be! The day after, a bit anxious, you check your account only to see that the stock has gone up 10%! What a great feeling. And the cherry on the cake? The investments in your portfolio are also up. Today is going to be your day and you are eagerly looking forward to tonight’s dinner to share your success story with your circle of friends.
A few months later, a series of negative news reports hit the markets; most stock markets are down, and the trends seem like they are here to stay. Your investments are down too and some of your financial gems are suffering to the point that you are considering selling everything. Luckily the stock of this biotech start-up you really like is still up 24%. You have an appointment this afternoon with an advisor to discuss insurance policies, but you are really not in a mood for that. The economic situation could worsen, and you wonder if it is really a good time to invest more. Surely, the situation will be better tomorrow, you just need a good night’s sleep. But tomorrow brings more bad news. The biotech start-up you have in your portfolio is down 50%. Their vaccine submission was rejected by the health authorities. That’s enough. You’re done with investing.
Three Familiar Old Friends
Although these stories are slightly exaggerated, they do paint a clear picture of the kind of emotions we go through when investing. Now, let’s cross the barrier of our skull to see what happens inside our brains.
When faced with gains or prospect of gains, such as the ones mentioned in our first story, complex interactions take place inside our brain, resulting in highly pleasurable emotions. Recent research links this to the activation of our “reward system”, the same system that is activated when we see our favourite dessert or engage in sexual activities. This reward system involves several parts of our brain and a specific neurotransmitter called dopamine. It is the release of the latter that could explain the sensation of greed we experience when we see our investments perform well. So, we are physiologically predisposed to experience pleasure when investing. However, when we experience a series of gains, our reward system goes wild. A bit like an addiction, we are prone to take more risks to feel this sensation again.
Investing involves risks, and as rational as we like to think we are, when these risks start to surface, it triggers a reaction of fear. A specific part of our brain, the amygdala, comes into play. Fear is a powerful mechanism that can help us act in dangerous situations. It also greatly affects our capacity to think and sometimes prompts us to take the wrong financial decisions, like selling our investments too quickly or overestimating risks that affects us.
Last but Not Least: Pain
I have long wondered why experiencing financial loss was so unpleasant. Again, part of the answer can be found in our brain, in a part called the anterior insula. Basically, a financial loss triggers a sense of pain or disgust similar to what we experience when we see something we don’t like on our plate. And a series of losses can cause us to give up on investing for a while just to avoid this uncomfortable sensation. And social pressures add to this. The fear of revealing the state of poorly performing investments to enquiring friends is a cause of great anxiety for many.
Finding the Middle Path
Now that we have an idea of the emotions at play and their impact on our investment decisions, let us see how we can deal with them. The point is not to try and suppress emotions – they play a key role in human cognition – but more to acknowledge when they kick in and avoid states of stress and anxiety that can have long-term impact.
The first thing you can do is to work on your emotions directly. It is no surprise that some of the greatest investors practice yoga, for example. It is well worth the time and effort it takes to develop techniques and explore outlets that can help us keep a cool head in trying moments.
The second thing is to embed safeguards in your investment decision-making process. You could:
- Enter the market gradually or only on your own terms, test your investment hypothesis, calibrate your bets adequately or simply accept to pass on investment opportunities (don’t worry, the markets will provide you with many more), enabling you to avoid being carried away by the “greed rush”.
- Stick to facts and focus on the long term to help fight off the negative consequences of fear, such as selling too quickly or falling in paralysis.
- Diversify your portfolio, have clear rules for when to sell, not take losses personally and sometimes accept to be less involved. This can help you avoid the sensation of pain or disgust.
It takes time to get used to your own emotions but ultimately building a successful investing process is as much a matter of knowledge as it is a matter of self-control. And the good news is that with a little focus and patience, we can cultivate both.
- Adaptive Markets, Lo, Chapter 3. Princeton University Press
- Functional Imaging of Neural Responses to Expectancy and Experience of Monetary Gains and Losses
- The Neural Basis of Economic Decision-Making in the Ultimatum Game
- Addiction by Design: Machine Gambling in Las Vegas
- What neuroeconomics does really mean?
Alpian has submitted an application for a full banking license to Switzerland’s Financial Market Supervisory Authority (FINMA). Content of this publication is for informational purposes only, you should not construe any such information as legal, tax, investment, financial, or other advice.