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| The Basics | Bingeing on stocks? Its biology
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Are impulsive money moves wrecking your returns? Here's how to keep yourself in check.
By Kiplinger's Personal Finance Magazine
You buy a risky stock impulsively. You beat yourself up over an investment that's losing money, but you can't bear to sell it. You know you should stash more away for retirement, but you never get around to it.
For most investors, these types of seemingly irrational, shortsighted decisions are nearly as automatic as flinching when a bug hits the windshield. But with the help of a new branch of science, neuroeconomics, investors can learn how to resist their self-destructive tendencies.
Neuroeconomics shows that our brains are wired with two different systems, each struggling for control of our financial decisions. Call it the battle between Dr. Jekyll and Mr. Hyde. The Jekyll brain, the prefrontal cortex, is highly evolved and rational. The Hyde brain, or limbic system, is more primitive and reactive. All too often, says Kevin McCabe, an economist at George Mason University, in Fairfax, Va., Mr. Hyde takes control, even "when it's not in our best interest."
Experiments reveal that Mr. Hyde's power can be striking. For example, researchers at Stanford University had students play a simple game in which they could win or lose money depending on how quickly they pushed a button. During the game, an MRI machine scanned the students' brains. Scientists discovered that the thought of making money pushed the reward system of the students' brains into high gear. That system releases dopamine, the pleasure chemical of the brain, which is the same chemical that spews into the brain when we see images of sex or sports cars. The bigger the perceived reward, the more dopamine. The more dopamine, the more emotions control your decisions.
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Sexy but dangerous
Brian Knutson, who runs the Stanford lab, says that although the experiment didn't focus on investing decisions, you can draw some conclusions. Says Knutson, "If you're thinking of how sexy a stock is or how fast its price is rising, but not thinking about how it compares with other investments -- in other words, if you're acting on the basis of excitement -- you'll make bad decisions."
Moreover, when we see opportunities for big rewards, we tend to downplay the potential risks. The part of the brain that kicks in during the presence of high-reward opportunities "responds to how much you think you can make, but not probability," says Knutson. "It's like wearing beer goggles and going after the hottest woman at a party."
Jekyll and Hyde also duke it out when you must choose between long-term and short-term gratification. Put simply, the emotional system is "impulsive and myopic," says Sam McClure, a researcher at Princeton University. He helped engineer an experiment at Princeton in which students could receive Amazon.com gift certificates either immediately or up to six weeks later. Brain scans showed that the promise of an immediate reward set off an emotional response -- Mr. Hyde "wants things now," says McClure.
But when given a choice between rewards of varying amounts at different times in the future, Dr. Jekyll prevailed. For example, offered a choice between a $5 gift certificate in two weeks or a $40 one in six weeks, most participants in the experiment delayed gratification for the larger reward down the road. Says Harvard economist David Laibson: "Our emotional brain wants to max out the credit card, order dessert and smoke a cigarette. Our logical brain knows we should save for retirement, go for a jog and quit smoking."
Mr. Hyde is virtually incapable of thinking about the future. Neuroscientist Jordan Grafman's research for the National Institutes of Health discovered that Vietnam veterans with injuries to the prefrontal cortex struggled when making long-term financial decisions. "They had a difficult time articulating goals for the future, especially far into the future," such as planning for retirement or saving for their children's education, says Grafman.
Scientists have found another component of our neural wiring that hamstrings financial decision-making: We are programmed to see patterns. "At a very deep level, it's what our brains do," says Scott Huettel, a psychiatry professor at Duke University. This ability is useful in the natural world, where there is often good reason to assume a pattern is meaningful. In the days when humans were hunter-gatherers, for example, a man who found three nests that contained eggs would check a fourth nest.
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