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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. More from Kiplinger's Personal Finance and MSN Money 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. Nowadays, though, that kind of assumption could cause problems. For example, you see red come up three straight times on a roulette wheel. What do you do? Bet next month's mortgage payment on red? Or, worse, you note that Tyrannosaurus Technology's stock has risen three days in a row. Do you buy it? In investing, the pattern we see is often a coincidence. But the subconscious part of our brain urges us to act on this pattern. It may override the rational part, which may see, for instance, that the stock of the company that just had a good run is wildly overpriced. The broken pattern Now what do you do if you reach into that fourth nest and a snake bites you? You'll almost certainly start giving nests a wide berth. When a pattern is broken, your brain generates feelings of fear and revulsion -- which is a good thing because it lessens the likelihood of future snake bites. But that is not necessarily a desirable outcome for investors. If a company releases a poor earnings report, you may sell the stock even if it is still a sensible investment, or you may be so disgusted that you do nothing when, in fact, you should sell the stock. Because our minds are wired to avoid the unpleasant, bad memories last much longer than good ones. Stanford's Knutson, a professor of psychology and neuroscience, says that positive stimulation is short-lived. "Those mechanisms turn on and off quickly," he says. "But if you're scared by a saber-toothed tiger, you'll be scanning the bushes for the next three years." Trusting patterns is one thing. But what about trusting people? Science has something to say on that subject, too. The "trust game" has become a staple of neuroeconomic research. Variations exist, but basically the game involves a trustee and an investor. The investor sends the trustee money and the rules of the game say that that mere act automatically expands the amount of cash. The trustee may then share the wealth with the investor and return some of the money or -- and here's the rub -- the trustee may burn the investor and send back nothing. You might think that behavior in such a game would be based on a simple financial calculation: "I'll send more money if I get more back." But Paul Zak, an economist at Claremont Graduate University, in Claremont, Calif., says trust is an emotional response. The hormone oxytocin fills different areas of the brain in social situations, such as bonding between spouses or between parents and children. "We are a social species, and it's a good thing that we can learn how to trust," he says. As the trust game shows, a certain amount of cooperation between parties benefits both of them. Just how powerful is oxytocin? In a version of the trust game, Zak and other researchers discovered that simply squirting a dose of oxytocin up a test subject's nose prompted the person to give the trustee more money. Whats the solution? Although neuroeconomics identifies the reasons for our actions, it's less helpful in prescribing corrective measures. But that doesn't mean you have to wait a few hundred thousand more years for your brain to evolve to the point that you can approach your finances more rationally. The overarching rule is that investors must learn to recognize situations that will set off emotional decisions. "Then you can place yourself in a circumstance that doesn't require you to make snap decisions," says Grafman, the NIH scientist. When it comes to trust, for example, you shouldn't act on someone's financial advice just because you like the person. "If your tennis partner tells you about a stock, stop and think about it," says Claremont economist Zak. If you are presented with a high-reward opportunity -- say, a broker calls with a hot tip on a penny stock -- wait. Acting on impulse means you won't properly weigh the risks involved. Let your Dr. Jekyll spend some time researching the stock -- no sense in having a highly evolved brain if you don't use it. And be aware of patterns. Sometimes they're valid, sometimes they're not. Get the big picture about a company before investing. Follow these other simple rules, and you stand a much better chance of moving the investment decision-making process into the rational part of your brain:
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