A look at how our irrational brains tick

Aug 20, 2007 @ 12:01 am

By Mike Clowes

The human brain is a wondrous thing — of that there is no doubt. But when it comes to investing, our brains frequently betray us.… We can begin to understand what drives investing not only on a theoretical or practical level but as a basic biological function.”

For one, they insist on finding patterns in data even where none exists. In a typical example, researchers flash two lights on a screen, one red and one green. While the lights flash randomly, the green light flashes 80% of the time, the red, 20%.

Humans, instead of picking green every time and having an 80% chance of being right, pick green about 80% of the time and try to guess when the next red light will flash. As a result, they’re right just 68% of the time. Rats and pigeons, in contrast, when rewarded with food for the right pick, quickly learn to choose green every time.

“For decades, psychologists have demonstrated that if rats or pigeons knew what a stock market is, they might be better investors than most humans are,” Jason Zweig, the brilliant senior writer at Money magazine in New York, writes in his forthcoming book: “Your Money and Your Brain.” It will be published by Simon & Schuster in September.

This is a book every financial professional should read — and reread at least annually. It will give them insight into the investment decisions they make for themselves and for clients.

“The 100 billion neurons that are packed into that three-pound clump of tissue between your ears can generate an emotional tornado when you think about money,” Mr. Zweig writes.

Understanding why we and others do silly things that we know are not in our best interest is a key step in changing our self-defeating behavior. The book’s main goal is to provide that understanding.

In the first part of the book, Mr. Zweig outlines the discoveries of experts in the relatively new field of “neuroeconomics.”

Over the past few years, he writes, “scientists have made stunning discoveries about the way the human brain evaluates rewards, sizes up risks and calculates probabilities. With the wonders of imaging technology, we can now observe the precise neural circuitry that switches on and off in your brain when you invest … We can begin to understand what drives investing not only on a theoretical or practical level but as a basic biological function.”

Economists have long insisted that investors use information logically, notes Mr. Zweig. “In practice, however, those assumptions often turn out to be dead wrong.”

Among the key discoveries of neuroeconomics are:

• A monetary loss or gain is not just a financial or psychological outcome but a biological change that has profound physical effects on the brain and body.

• The neural activity of someone whose investments are climbing is no different from that of someone high on cocaine or morphine.

• Financial losses are processed in the same areas of the brain that respond to mortal danger.

The chapter titles give an idea of the scope of the book: “Knowing vs. Feeling,” “Greed,” “Prediction,” “Confidence,” “Risk,” “Fear,” “Surprise,” “Regret” and “Happiness.” Each chapter outlines research that provides insight into how investors relate to these topics and how they should relate.

Regarding confidence, for example, research shows that we all overestimate our abilities in many parts of our lives. “Positive thinking can be useful, but extreme optimism is dangerous,” notes Mr. Zweig. He concludes the book with three appendixes of advice to investors. These could profitably be shared by advisers with their clients.

I repeat: Every adviser should read this book at least annually.

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