Behavioral Finance

For most researchers working in neuroscience, the Holy Grail is to discover how to regenerate the neurons of the brain. Such a feat would help scientists put an end to diseases such as Parkinson’s, Alzheimer’s and many forms of dementia. But others are taking the techniques of this growing field and applying them to behavioral finance, itself a mash-up of economics and psychology. The result is a new field called neuroeconomics, which attempts to explain how people manage risk and why they often make irrational decisions.

That emotions play a powerful role is nothing new. Benjamin Graham, considered the father of value investing, once said, “Individuals who cannot master their emotions are ill-suited to profit from the investment process.” But the core theories of the field now known as Behavioral Finance were developed by Daniel Kahneman of Princeton University, whose work, with the late Amos Tversky, won him the Nobel Memorial Prize in Economic Sciences in 2002. Kahneman and Tversky found that people suffer a higher degree of pain from losing money than they feel pleasure from making money. So they tend to hold on to losing stocks rather than sell and lock in a loss.

R.J. Weiss, the 26-year-old founder of the blog Gen Y Wealth, recently posted that he got caught in a behavior trap. When his grandfather passed away, he inherited shares trading at $25. As the shares fell to $20, to $10 and then to $5, Weiss couldn’t bring himself to part with his grandfather’s gift. Finally, in April, he sold at $3.04, locking in a 90 percent loss. “The entire time the stock plummeted, I knew [that holding] was the wrong thing to do. But I couldn’t get myself to sell it,” wrote Weiss. Irrationality can take the form of an emotional attachment to an inanimate asset.

John Coates, a senior research fellow in neuroscience and finance at the University of Cambridge, has a theory. He says there would be fewer stock market bubbles and crashes if women and older men handled most of the trading. “There is less diversity in the financial world than in the military,” he quips. “On Wall Street, we have one slice of the population — young men — running our trading floors. That leads to extreme behavior: They go wilding.” Wilding is not good for stocks. Such behavior likely contributed to the Internet crash in 2000 and the subprime-fueled crash of 2008-2009.

In 2007, Coates went to a trading floor and took repeated saliva samples from 250 traders, mostly young men. He found that in the mornings, when their testosterone levels were high, the traders’ confidence was also high. As they made winning trades, their testosterone levels rose even higher, leading to profits in the afternoon. The young men began to feel infallible, indulging in increasingly risky behavior, such as buying shares of overvalued stocks. But eventually too much testosterone, too much impaired judgment, would drive markets to unsustainable heights. Then the cycle could end. The overvalued stocks would crash and the testosterone levels would return to normal. “Testosterone is the molecule that explains irrational exuberance,” says Coates. “A certain amount of testosterone can be healthy, but too much can lead to a bubble.” A more immediate solution may come from John Coates’s research: Adjust the mix of traders to include more women and older men.

Investors with the biggest appetite for risk have increased brain activity in an area called the nucleus accumbens. That’s the part that lights up in an animal when it finds food or in a predator when it goes for the kill. At the same time, there’s a surge in the feel-good chemical dopamine. It floods your brain when you anticipate doing something pleasurable or exciting such as sky diving, listening to music or having sex. A dopamine high can cause investors to engage in risky behavior.

However if going really wild means moving from a three month Treasury bill to a one-year certificate of deposit, you’re probably suffering from Irrational Prudence Syndrome, a non-medical but widespread condition that results from overexposure to volatile markets. IPS is characterized by extreme aversion to equities and uncontrollable urges to stuff cash into government guaranteed mattresses, be it a CD, a Treasury security or even a checking account. It’s a syndrome financial firm’s dread, and one they are determined to cure. Left untreated, IPS can lead to poorer investors — and frustrated advisers.

Are retail investors’ expectations upside down? High when conditions are bad for investing, low when conditions are good? Is there a better way to anticipate what’s going to happen to your investments?

The answer is: yes and yes.