Emotion Can Make You a Bad Investor
Investors often make choices that make no logical sense but perfect emotional sense, argues financial journalist Jason Zweig in his new book, Your Money & Your Brain: How the New Science of Neuroeconomics Can Help Make You Rich. He spoke with reporter Emily Brandon about how to overcome your brain's natural urges to become a better investor.
When investors experience a monetary loss or gain, what kind of physical effect does it have on the body?
The brain processes expectation in a much more intense way than it processes the actual experience. So, the hope of making money often feels better than actually making money does, and the fear of losing money often feels worse than actually losing money. And those are the two states that often drive your behavior.
Why do our brains respond so powerfully to money?
The human brain developed to solve the very simple problems of finding food and shelter, courting mates, and avoiding danger, and our ancestors had to make simple calculations about risk and reward, all in the absence of money. In the modern world, almost every risk and reward that a human being faces is either symbolized or mediated by money. Money is not a reward in itself, but there are very few rewards you can get where you don't need money. Money taps into the most ancient and powerful emotions that the human brain can experience, and because of that I think a lot of people, when they are making financial decisions, really feel they are thinking and deliberating. What they often don't realize is they are really deciding with their emotion.
How can you prevent being knocked off track by your emotions?
Have policies and procedures in place in advance so you don't jump from decision to decision. You shouldn't make your choices based on what the stock market is telling you and based on what other people are doing, but rather on the basis of rules you are putting in place in advance. You can invest with a rule or a procedure, such as I will always keep 70 percent of my money in the stock market, as an example. If you committed in advance, when the market crashes as it did this summer, you will find that you have less than 70 percent, and that means that you must buy more. In general, if you buy when most of the news is about how everyone else is selling, you'll probably do much better. A rule that forces you to go against what your emotional brain is telling you is almost a certain way to get better results.
When investing, should you discard your first impulses altogether?
Many people should. Investing should be as close to an automatic process as you can possibly make it. For many people it's more like a hobby. They see something they like so they buy it, or they find out something they don't like so they sell it. It's a lot like collecting Beanie Babies. You should have policies for making very broad and very simple decisions. The more you can make it a policy and an automated process, the less likely you are to have your emotions be hostage to the state of the markets and the 100 million other people who are investing alongside you. Because if you take your impulses from what they are doing, you'll always be as crazy as they are.
Why are most people convinced they can find patterns in the stock market and make predictions?
The excitement you feel from thinking you are going to make money is very intense. If you've made some successful bets in the immediate past that have paid off more than once, you will really come to believe that you've got it all figured out. This sensation that I'm hot or I'm on a roll can lead to incredible euphoria. It also can be basically indistinguishable from a form of addiction. If you look at the brain of someone who has gotten a few stocks picks right in a row, it is almost indistinguishable from that of a cocaine addict, because the sensation is processed in the brain in almost the same way. You almost become addicted to the belief that you know what you're doing, and you may not know you're in the grip of these feelings.
Does someone like Warren Buffett have highly developed investing pathways in his brain?
The brain does not have investing circuitry. We don't have a little ATM machine in our head that accepts deposits and applies withdrawals. I think what makes an investor like Warren Buffett special—and his teacher, Ben Graham—is not that they're unemotional, it's that their emotions are inside out. The modern investing world in which we have cable TV and investing websites allows us to be continuously updated on what every investment we own is doing. Knowing more about the price of what I own does not give me the power to help it go up or prevent it from going down. You have to fight the tendency to think you are in control of your investments and instead develop the ability to be in control of yourself. You can't control what the market does. Getting constant information about it only gives you the illusion that you are in charge.—
Could there ever be performance-enhancing drugs for investing?
There's no doubt in my mind that perhaps in the next five to 10 years drugs will be developed that could help people be less euphoric when the market is at record highs and less miserable when the market is down in the dumps. The question is whether it would actually be good for people. If you're a professional trader with an investment bank on Wall Street, it might be good for you, and it could conceivably be good for the firm. But for the typical investor, I think you'd be better off going for a walk around the block.
You went through a lot of different brain scans in writing this book. Are you worried about how that's going to affect your bottom line?
There's no evidence that having multiple MRI scans of your brain does any damage. The good and the bad news is I learned I am a very typical investor with the standard limitations. I also learned that my own investing plan is a pretty good one, which is to trade as seldom as possible, to keep my costs as low as possible, and to make as few decisions as I possibly can. I can instead invest according to a policy rather than in reaction to what the market is doing in front of me.
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