Investing and your brain: Why we hit the panic button

August 25, 2011

Weathering the storm has lost popularity points with investors in the latest round of market volatility, prompting some to wonder if panic and irrationality are the name of the new game.

Investors pulled $31.3 billion out of U.S. equity funds in the two weeks ending August 10, reaching outflow levels not seen since the stock market collapse of March 2009.

Finding the reason behind that seemingly irrational sell-off may require more analysis than most economists or stock market watchers can perform. Perhaps the motivations behind our investing decisions are actually a question better put to neuroscience.

“Certainly, economic fundamentals play a valuable role in the value of assets and the prices that things trade for. But when individuals are making buy-and-sell decisions they can be very influenced on what is going on in their brains, including emotions,” says Lisa Kramer, associate professor of finance at the Rotman School of Management at the University of Toronto. Kramer has done extensive research on how human emotion — specifically in relation to seasonal depression — influences financial decisions and financial markets.

“We’re prone to weighing recent information more heavily than more historical information. The fact that we’ve just been through a financial crisis in the last couple of years is looming large on our minds,” she says.  “When we see things start to go south again in the market, we go to that bad place in our minds and I think that can drive us to act impulsively more so than we would have a few years ago before we lived through this kind of volatile period.”

This historical hangover, coupled with the understanding of the body’s risk/reward system, has lead researchers to hypothesize that an investor’s urge to buy or sell at the wrong time could be a by-product of our neural processes overriding reason.

Kramer explains if one were to do a functional MRI analysis while an investor was in the process of making a financial decision — let’s say whether to buy a stock or a bond — “you’ll find that the part of the brain that’s activated when somebody makes the risky choice is called the nucleus accumbens (NACC) and it’s activated when people are experiencing pleasurable, things like food or sex. The part of the brain that’s activated when people make the safe choice is called the anterior insula and it’s more associated with pain and fear,” she says.

Richard Peterson, M.D., a former quantitative trader and managing partner at MarketPsych, agrees, adding investors are still experiencing anger and mistrust of the financial services industry.

“When people feel disgust, it activates the anterior insula. That area of the brain is known to prevent risk taking,” he says. “Since the crisis began, no more money has entered the market. In fact, it has stayed out entirely. People are not reinvesting, they’re feeling disgusted, our data shows that, and it appears to be through this neural mechanism.”

Peterson writes in his paper “The Neuroscience of Investing: FMRI of the reward system,” that the brain’s reward system, connected to one of the brain’s five dopamine pathways, coordinates the search for, pursuit and evaluation of potential reward. The activation of this system, when it comes to collective investing, could have broader implications for financial markets and the economy.

Activation of the reward system results in particular types of behavior and emotion, characterized among investors as greater risk-taking, increased impulsivity, enhanced positive feelings, and greater physical arousal.  Loss avoidance behavior and emotions are timid, protective, fearful, and risk-averse.  When activated among large groups, reward approach behavior can impact the economy as a whole, leading to stock market bubbles, increased consumer purchasing, higher investment risk-taking, and an increased use of credit.  Loss avoidance, on the other hand, is seen when people decrease borrowing, sell off assets, and report decreased financial confidence (and even fear.)

In terms of behavioral finance and investing,  Franklin D. Roosevelt was spot on when he made the now-famous quote “the only thing we have to fear is fear itself,” says Brian Bruce, CEO of Hillcrest Asset Management and managing director of the Center for Investment Research.

“The volatility is of our own making. The thing we fear the most, because we fear it, we create it,” he says. “The frustrating part is you can create this self-fulfilling prophecy. Even if we aren’t headed for a recession, if  everyone is scared to death — consumers stop spending, businesses stop hiring and stop investing —  than you’ll create one. If you just act normally, things will be fine.”

Advisers are experiencing the by-product of these emotions, even for clients in a defensive portfolio position. When it seemed the markets were on an upswing earlier this year, investors were hungry for gains.

“Over the past six months, I’ve had to explain to more clients why they need to stay defensive rather than chasing returns.  I can lock in a return of eight percent at some point this year which could turn into a loss of seven percent in two weeks,” says Jeff Link, partner at Guardian Capitol Advisors LLC. “I have more conversations with clients where I’m trying to get them to stay the path we’ve laid out for them even though it looks like we may be wrong.”

So, what does this type of research mean for the financial services industry? Understanding an investor’s fight or flight mentality is integral to advisers, writes Gregg S. Fisher, a CFA and CFP, in his paper “Behavioral finance from a practitioner’s viewpoint.””For those of us focused on the risk side of the equation, understanding the behavioral component of the decision-making process is essential to our understanding of market dynamics – particularly in periods of financial stress like the past decade, in which we saw two equity market corrections of approximately 50 percent each,” he writes.

For investors? There are periods of market volatility and uncertainty that will determine prices, but rational analysis of fundamentals will eventually prevail. Tune out the market chatter and listen to your adviser. “The markets are overly driven by emotion and those that will profit will understand that they need to take that emotion out of it and stay calm. Invest on the facts,” says Bruce.

Just make sure you and your adviser are on the same page, Peterson advises. “If you don’t resonate with your adviser, you’ll jump off the [investment] plan even if it’s solid. If you don’t buy into them or don’t trust them, you’ll panic when markets are down 23 percent.”

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