Turbulent times in financial markets will predictably stimulate powerful non-rational behaviours among even the most seasoned investors. Managing client emotions can be one of the greatest challenges facing financial advisers. And most of the problem rests with the human brain.
Thousands of years ago, humans protected themselves by gathering into groups, developing tools and weapons, cultivating fields, breeding livestock, building villages, and surrounding villages with walls. These advancements were driven by the desires to increase security and minimise risk.
As civilisation advanced, currency became a way to manage risk, and people began to accumulate wealth in the form of money instead of possessions. Investments were known as “securities” because money offered a feeling of security and certainty about the future. As people needed less protection from wild animals and invaders, they began protecting the process of accumulating wealth.
However, although civilisation has advanced dramatically over the past 50,000 years, our brain, central nervous system and survival instincts essentially remain as they were back in the prehistoric era. The result is an odd contradiction in how we experience money and investing: our rational, educated and modern brain thinks one way while our emotional, instinctive and primitive brain reacts very differently.
As Edward O. Wilson the Pulitzer Prize winning author of On Human Nature once said, “The real problem of humanity is we have Paleolithic emotions, medieval institutions and God-like technology”.
The science on this thinking centres on the concept of our “two brains” – the brain stem and the neo-cortex. Investors perceive information and process it in the primitive portion of the brain, the brain stem. The brain stem is focused on survival; it controls our instinctive fight-or-flight reaction and other basic motivating functions. It’s similar to a crocodile’s or frog’s brain: very primitive and focused on eating, mating or protecting us from danger. In simple terms, it’s where activity is generated and where the stimulus for motion is created. Its focus is on survival; it doesn’t have the complex, higher-order thinking that other parts of the brain use.
The neo-cortex has evolved over time to cope with more complex issues. It’s responsible for processing the information that the senses receive; it controls rational thought, language, long-term planning and the ability to interpret information needed to understand the world.
Understanding the idea of “two brains” is central to the challenge of investing. Investors perceive information and then, based on their personal experiences and interpretation, begin to react. Essentially, they perceive information and process it in the primitive portion of the brain; then the neo-cortex decides how to act.
When the primitive brain perceives information that is negative or threatening, this creates an instinctive reaction and causes a strong desire to seek protection. In many cases the fight-or-flight instinct is activated, which potentially results in terrible investment decisions.
This “two brain” concept is further compounded by what psychologist and author Dr Daniel Kahneman identifies as System 1 and System 2 thinking in his book “Thinking, Fast and Slow.” This book made popular the idea that we can divide the human mind up into two domains-System 1 and System 2. System 1 is a fast, automatic process that quickly sizes up a situation and jumps to a conclusion. System 2 is a slower, more deliberate process that attempts to work through the problem more systematically.
An example that Kahneman uses to see these two systems is the “ball and a bat” problem:
He poses the question “A bat and a ball cost $1.10 in total. The bat costs $1.00 more than the ball. How much does the ball cost?”
The “flash answer” that many people quickly conclude is that the ball costs 10 cents. For Kahneman, this is an example of System 1 scanning and jumping to what seems obvious. But if you think about it more carefully and work through the logic, you realise this is an error. If the bat was $1 more than the ball and the ball was 10 cents, then the total would be $1.20. After some deliberation, most folks can figure out that the ball costs 5 cents and the bat $1.05. This correction is the work of System 2.
Fortunately, science has revealed a way to become aware of these instinctual patterns.
Research shows that sometimes the brain uses automatic mechanisms or shortcuts to perceive and react to information. These are called heuristics and the study of how heuristics influence financial decision making is at the heart of behavioural finance.
Behavioural finance looks at how we use language, the origin of thoughts and motivation as well as the role of emotions in human decision making. In analysing how the human brain works, researchers have found some very unusual patterns embedded in the way our brain processes information. The patterns stem from for our reaction in moments of anxiety or urgency. We feel vulnerable when bombarded by more information than our brain can process so our brain turns to a mental shortcut, a built-in heuristic, to ease the challenge of deciding.
Dr Kahneman was the first to show how these patters are so built-in that most of the time we don’t even realise we are using them. In many cases these shortcuts work well enough for us to navigate the challenges of everyday life, and their appeal lies in the fact that we don’t have to work very hard to make a decision.
Over the course of his career, Kahneman uncovered numerous patterns of thinking, many of which significantly influence how we make investment decisions. Most of these patterns result in decisions that feel natural and correct but cause us to make investment mistakes.
One classic example is how we naturally distinguish between pain and pleasure. Kahneman discovered we are twice as motivated to avoid pain as we are to seek pleasure. This means we feel pain from an investment loss significantly more than we get pleasure from a gain. Even though mathematically it would make more sense to see losses and gains as similar measurements, it feels to us like they are not. Kahneman called this heuristic Loss Aversion.
There are many other examples of cognitive biases that we see materialise in our investment thinking.
The Availability heuristic is a cognitive bias in which you make a decision based on information, or recent experience that is readily available to you, even though it may not be the best example to inform your decision. For example, you read information about a plane crash and assume flying is dangerous when statistics show you are much more likely to die driving a car.
The Optimism bias leads us to believe that we are less likely to suffer a misfortune and more likely to attain success than reality would suggest. For example, we believe we will live longer than the average, that our children will be smarter than the average, and that we will be more successful in life than the average. But by definition, we can't all be above average.
The Gamblers Fallacy, also know as the Money Carle Fallacy, is a belief that if an event, whose occurrences are independent and identically distributed, has occurred less frequently than expected, it is more likely to happen again in the future or vice versa. The fallacy is commonly associated with gambling where you may believe for example that if a coin toss has revealed heads five times in a row, tails is more likely to occur on the next toss. In fact the odds are still 50 – 50.
The Anchoring Effect refers to our tendency to rely too heavily on the first piece of information offered when making decisions. This cognitive bias affects not only everyday choices but also has significant implications in professional settings, such as negotiations, pricing strategies, and financial forecasting. A striking illustration of anchoring is an experiment in which participants observed a roulette-style wheel that stopped on either 10 or 65, then were asked to guess what percentage of United Nations countries is African. The ones who saw the wheel stop on 10 guessed 25 percent, on average; the ones who saw the wheel stop on 65 guessed 45 percent. (The correct percentage at the time of the experiment was about 28 percent.)
The Endowment Effect is the tendency of people to value items in their ownership as being much higher than what they would determine the value to be if those exact same items did not belong to them. Somehow, the simple awareness of something being yours makes it all the more attractive than if it was not, hence the word endowment. For example, in an experiment conducted by Thaler, Kahneman, and Jack L. Knetsch, half the participants were given a mug and then asked how much they would sell it for. The average answer was $5.78. The rest of the group said they would spend, on average, $2.89 for the same mug.
All of these heuristics add significant complexities to the financial planning process. And the truth is that while we can’t change the way the human brain perceives information, we can change the way we react.
