The field of behavioral finance examines the intersection between psychology and economic decision-making. In his fascinating recent book, Your Money and Your Brain, Wall Street Journal columnist Jason Zweig examines a heretofore little-known aspect of behavioral finance: neuroeconomics, or how our brains respond in real-life financial situations. I recently sat down with Jason to discuss investor behavior and his tips for becoming a better investor.
: People may be familiar with behavioral finance. How is neuroeconomics different?
: What neuroeconomics does is take the high-technology tools of contemporary neuroscience, which center on the ability to observe activation in the brain at the regional level. So you're able to see which areas of the brain are activated under particular circumstances, and then you correlate that activity to behavior and also to the stimulus that triggered the activity in the first place.
So, for example, if our objective is to learn something about the brain processes that determine risk-seeking behavior, we might present somebody with the option to make a small amount of money or lose a large amount of money, and see what's happening at the level of neurons in that person's brain. The best-established finding is the evidence that Kahneman and Tversky presented roughly 30 years ago, that people feel the intensity of a loss about twice as strongly as they feel the pleasure of an equivalent gain. So losing $100 hurts 2 to 2.5 times more than winning $100 feels good. The neuroeconomic experiments tend to confirm that because they show that losing money activates parts of the brain that are associated with physical pain or disgust, like smelling vomit or stepping in dog doo. So that's the first level that confirms it.
: You went through some of this testing to examine your own brain's response to financial performance--in relation to some of these stimuli. What were some of the interesting things you found out about yourself?
: The first thing I learned wasn't particularly surprising to me, and certainly was no surprise to my wife, which is that I perform no better than anybody else, and in some cases worse, on the kinds of tasks that you might be presented with in one of these experiments. I think the only unusual thing about me is that I've been shown in at least one experiment to have an unusual degree of patience. I'm willing to wait considerably longer than the typical person to get a reward.
: And that's an advantage in investing.
: It is, but what's interesting about that is that that's not exactly what my brain scan showed. It's what a behavioral test showed. So it appears that through many years of training and discipline, and studying Benjamin Graham's work, and simply observing the markets and learning about financial history, I seem to have trained myself to become more patient than my genetic and biological makeup would suggest I naturally am.
The biggest and most surprising lesson to me came in an experiment that I did at Emory University. It was an example of what Gregory Berns, the neuroscientist who did the experiment, calls "learning without awareness." It turns out there are very powerful functions in the brain that enable us to recognize patterns without ever becoming aware we've been exposed to them. This pattern-seeking behavior in the human mind is just an incredibly powerful function. Most of us don't realize how automatic it is, and at what an involuntary level it occurs. So a lot of the trading behavior and what we might call "Cramer-like" behavior, where people see something happen two or three times in a row and just assume it's going to happen again, that sort of thing goes on in your brain whether you want it to or not. And it can drive your behavior even when you're trying to resist it unless you have formal decision structures in place to prevent yourself from acting on it.
In these particular experiments I was being asked to engage in a probability guessing experiment that required a lot of conscious thought, much like playing a game of checkers or backgammon. Simultaneously, I was being presented with a much more basic stimulus, which was that I was getting little sips of sugar water. And there was a pattern to the sips of sugar water that my conscious brain paid no attention to because I was trying to solve the more complicated problem. But the unconscious part of my brain soon detected what was happening with the sugar water. And the next thing I knew, I was pressing madly with my right index finger to indicate that I had solved the problem, even though I had no idea how I had done it. And it was simply that the pattern of sugar water had started to repeat and that part of my brain recognized this repetition, while the conscious part of my brain was still searching for a solution.
That sort of thing goes on all the time in the financial markets. And individual investors do it, and financial advisors too do it, without realizing it. You may end up investing more in a particular stock because you saw the CEO on TV and his necktie was your favorite color. It sounds absurd to think that people would make financial decisions based on irrelevant factors like that but they do. And the reason they do is that things like colors and sounds and smells and tastes and associations with our past and with ourselves increase our comfort and familiarity with a frightening world.
These kinds of effects are everywhere, and they surround investors, and they shape a lot of people's decision-making without their ever realizing it. The reason I harp on this issue again and again is that the single most exciting frontier in contemporary psychology is the exploration of these unconscious biases and the fact that unconscious influences on our behavior can skew our decisions in ways that are incredible to people. No one would ever believe that they married their husband or wife because the person had a last name that began with the same initial. But if you analyze millions of marriage records, that's exactly what you find.
Obviously you love your spouse, too, but you may well have been more attracted to him or her because of a familiar initial and that may actually be a large part of why you got married. I have no doubt that if we could analyze people's portfolios, we would find that they're overweight companies with tickers that remind them of their own names or their family's names--that they own a disproportionate number of stocks based close to home or where they grew up.