Join our community of smart investors

Free your mind

Understand your brain to achieve investment success. Rapid advances in the field of neuroscience are shedding new light on our crucial decision-making processes
March 23, 2017

How long have you been investing? Many Investors Chronicle subscribers have been actively managing portfolios for several decades, but the fact is - no matter how much experience we have in making financial decisions - our brains are not totally equipped for the job. This is not to say we cannot be successful, but we need to recognise that the parts of our brains we use are not specialised, having evolved to fulfil numerous other functions too. This makes us prone to adopt biases that were useful for survival in more primitive phases of our evolution, but which are detrimental to investing, as they can lead to suboptimal choices when buying and selling securities.

The most recently evolved part of our brains is the frontal cortex and this is the area responsible for complex functions of language and goal-setting that are unique to humans. To many scientists, the medial prefrontal cortex (MPFC) represents the 'thinking' part of the brain and intuitively one might assume this is what we use to make investment decisions. It isn't that simple, though, and scientists using functional magnetic resonance imaging (fMRI) and electroencephalogram (EEG) scans have noted that the possibility of financial reward also boosts activity in the nucleus accumbus (NACC), which is the 'pleasure centre' of the brain.

Pleasure and reward have an important role to play in humans. Also, the gratification we get from sugary food probably helped our ancestors get a necessary kick to carry on hard tasks when food was scarce. Likewise, the warm glow we get from achievement helps motivate us for further endeavours. Therefore, we should perhaps be unsurprised when our thinking and pleasure centres are stimulated simultaneously. It makes sense that early humans would have needed to combine emotional and logical intelligence when going about activities essential for survival, such as hunting in parties. Yet this combined function might not be a good trait for investors, as too much emotion in decision-making can lead us to reach poor conclusions.

In 2004, work by Richard L Peterson (with additional data from Brian Knutson) at Market Psychology Consulting made significant progress in mapping neurological responses that are likely to be seen in investors. Dr Peterson's study used fMRI technology to visualise the origins of buying and selling behaviour in the brain - revealing discernible patterns in brain function to work towards a scientific explanation of the positive feelings we have when buying shares and our more timid behaviour when engaging in loss-avoidance.

Modifying information to stimulate research subjects, Dr Peterson undertook a process of systematic experimentation and discerned interesting patterns in activity through the brain's reward system, which includes how the NACC and MPFC (pleasure and reward centres) interact. The 'pleasure chemical' dopamine is one of the few substances in the field of neuroscience that is known beyond research and clinical circles. Its rate of uptake in the reward system is central to the study that tracked the dopaminergic neurons which carry dopamine. Several stimuli were found to activate the reward system in experimental subjects' brains. Chocolate, sweet foods, pictures of attractive people and, most pertinently for investors, money, were all found to be effective at stimulating dopamine transit.

One of the main findings was which parts of the brain were most active when items were anticipated and when they were actually received. In Dr Peterson's summation: "Anticipation of reward activates the NACC [pleasure] while reward outcomes activate the MPFC [thinking]." This is important for investors as it reveals that there is significant scope for emotion to play a role in buy and sell decisions. Indeed, this explains why some people enjoy risky activities such as spread betting and speculating on penny shares.

Money was a useful incentive to experiment with for the study as it gave the opportunity to manipulate the timing, size and probability of rewards. This enabled Dr Peterson to observe responses to different magnitudes of financial reward with varying probabilities. The conclusion he reached was that brains are much more responsive to the size of rewards than their likelihood. This is an interesting finding and supports the previous (largely anecdotal) evidence that investors are attracted to 'lottery stocks', which carry the promise of outsize returns. These types of company, for example technology start-ups or junior mining stocks, could deliver a 10-bagger, but also have more potential to go bust than, say, a boring utilities stock. In terms of longer-term portfolio planning, the lower propensity to process information on probabilities relative to reward size could also help explain why so many investors have difficulty choosing the best asset allocation to meet their needs.

  

Behavioural finance is rooted in the workings of the brain

More recent work, such as that of University College London (UCL) academic Dr Tali Sharot, has focused on specific patterns of bias in humans. In her 2011 book, The Optimism Bias, Dr Sharot discussed her extensive research into why humans are neurologically wired to look on the upside. Dr Sharot has found that in fMRI images, stimulating thoughts of sought-after events cause more vivid brain activity in subjects than less valued events. This bias is stronger in the most optimistic subjects and shows up with more vibrancy in two regions in the brain. One is the amygdala, which is a small structure central to the processing of emotion, and the other is the rostral anterior cingulate cortex (rACC), the area of the frontal cortex that modulates the flow of emotion and motivation. In depressed people, these areas showed abnormal activity.

The title of Dr Sharot's book chimes with works by famous researchers in the field of investment such as Triumph of The Optimists by Dimson, Marsh and Staunton, which details the phenomenal performance of equities in the 20th century, despite two world wars and the Great Depression. One interpretation of the historic total returns premium equities have given over 'risk-free' US government 0-3 month treasury bills (which stands at 4.2 per cent for global shares between 1900 and 2016) is that human optimism has won out.

The long-term performance of equities and even more vital litmus tests, such as the growth in human life expectancy and the expansion of the population, bear testimony to the evolutionary success of our tendency to look on the bright side. Evolution is not an entirely smooth trajectory, however, and what collectively may look like a beneficial human trait can, in individual cases, lead to harmful outcomes. Being aware how the optimism bias works and manifests itself in our judgment calls should help investors recognise when they are engaged in certain behavioural patterns, which they can arrest before damaging actions are taken.

One of the illuminating features of Dr Sharot's work is the way in which people seem to learn more from positive rather than negative information. Basically, our brains have not developed as well to register bad news. This applies to news that affects us personally and another interesting finding is that people tend to be more pessimistic about wider society and the economy, but are optimistic about their own prospects. Dr Sharot's research team found when monitoring brain activity in subject, that the left frontal gyrus (the part of the brain that registers optimistic emotion) was far more responsive when showed positive statistics, for example that prices in the housing market were going to go up, than the right frontal gyrus (the part of the brain that registers pessimistic emotion) was when showed negative statistics, such as the likelihood of going through divorce or developing cancer.

The downside of this is that, while we may accept warnings such as 'smoking kills' or that 'penny stocks are risky', our brains work to make us underplay these risks. In other words, smokers convince themselves they'll be one of the lucky ones and rejig the probability of their personal cancer risk to something smaller than the statistic for the overall population. Similarly investors in risky stocks believe that the tech start-up or junior resources company they hold will not be one of the duds. The dangers of this optimism are evident, as Dr Sharot has pointed out, in the reports made by firefighters into fatalities. These professionals know the unpredictable nature of fires better than anybody, but the phrase "we didn't expect the fire to do that" cropped up in reports with alarming regularity. An explanation for accidents happening is that the firefighters' brains encouraged them to take risks even though they were aware how dangerous it is not to expect the unexpected in their line of work.

This aspect of brain function probably explains some of the recklessness that culminated in the financial crisis. It can't have been a surprise to everybody that the US sub-prime market blew up, but the people who repackaged the bad mortgages into tranches of collateralised debt obligations (CDOs) had managed to kid themselves. Individuals are wired to believe they will continue to make money, not focus on the potential (and likely) knock-on effects of defaults that, thanks to the complex nature of the products they were selling, seemed distant to their day-to-day activities. Their brains simply declined to register the risk of a catastrophic systemic collapse, even though they would have understood it was possible.

Our optimism bias sets us dangerous traps, but without it humans would be less innovative and less likely to strive to improve our situation. Optimists work longer hours and tend to earn more than pessimists and while they are no less likely to suffer misfortunes such as divorce, they are more likely to remarry. Also, we often hear anecdotes from entrepreneurs who talk of their failed business ventures before stumbling across the big idea that made them wealthy. Some technological advances happen as groups of people with similar ideas all take the chance that they will discover the secret sauce that makes an idea profitable.

Social media is a great example in the past decade. Facebook (US:FB) benefited enormously by learning lessons from the first canaries down the mine, the likes of Friendster and Napster. Scientific progress is owed to each generation of inventors and theorists, who don't always get the recognition they deserve or any financial reward. As Sir Isaac Newton acknowledged: "If I have seen further it is by standing on the shoulders of giants." If those giants hadn't been optimists, the great Newton would have started much lower down.

 

How well do you know your own mind?

So, optimism should be celebrated and as studies such as Triumph of the Optimists show, over the long run investors really can be rewarded for taking risks. What we need to remember, however, is that our brains play tricks on us. This is probably a necessary trait to ensure the success and propagation of our species, as it encourages us to be inventive, productive and to procreate. At the individual level, we need to take steps to ensure our hopes and aspirations don't become collateral damage in the onward march of humanity. To reduce the number of bad investment choices we make, being conscious of the working of our minds is highly worthwhile.

The human brain is immensely complex - scientists estimate that on average there are more than 100 billion neurons with 100 trillion connections - so clearly we aren't going to be able to come up with investing strategies based on neuroscience. What we can do is understand more about our likely responses to situations and set out our investing discipline to mitigate cognitive weaknesses.

A good place to start, as alluded to in the recent update of Investors Chronicle's 10-asset portfolio, is in choosing an asset allocation and rules-based system that you are comfortable with. Make a realistic estimate of the downside risk in your portfolio and ensure that you have the capacity to endure it. If there is a nasty sell-off you want to be in a position where your income and cash needs are taken care of and you can sit tight and ride out the rough times. Alternatively if, to avoid peak-to trough drawdowns, you do want to retreat to cash in bear markets then have a rule in place, for example selling a security when its price falls below its 10-month moving average, so that you are acting on a pre-considered plan, not panic or impulse. This is important because when we are stressed different types of brain waves become prevalent and alter behaviour.

Two of the main types of brain wave are alpha and beta waves. The alpha waves, which have a lower frequency of eight to 12 hertz (hz) have been observed strongly in the occipital and parietal regions of the cerebral cortex. The occipital lobe is associated with how we process visual information and the parietal lobe, while it has some role in the spatial awareness aspect of vision, is more associated with our sense of touch. The parietal lobe is also involved in the way we understand numbers and their relations, as well as in language processing. Given that investors need to make sense of fundamental data and also the narratives surrounding asset classes and individual companies, this is potentially significant.

Alpha waves are important in integrating our conscious and subconscious actions - when we have too much alpha we tend to daydream and be unproductive, but when we have too little we are anxious and stressed. It is not conducive to investment decisions if parts of our brain involved with processing data and narratives are affected, a reason panic buying or selling is to be avoided.

Under stress, we see the balance of waves in the brain tilt towards beta waves. These have a higher frequency of 12hz and upwards and are of a shallower amplitude. Drugs exist called beta-blockers to help those afflicted by severe nervousness or anxiety, but when the brain is functioning well beta waves are important in maintaining focus, problem-solving and memory. In 2014, Dr Andrew Hill of the Alternative Brain Institute in California conducted a study on traders from Sang Lucci Capital Partners, and he noted they had a higher than average amount of beta frequencies. This, he deduced, was because their work involves continual furious thinking.

When brain function is optimal, there is the right balance of alpha and beta waves. In this situation the alpha waves are strong enough to ensure that we are mildly relaxed but the beta waves provide the focus to solve problems and remember clearly, without becoming overpowering and causing flustered thinking. You might call this state being 'in the zone' to attain at our highest level.

Trading forums are awash with methods to train the brain to work at its best, and dietary supplements called Nootropics are available to try to stimulate the perfect blend of alpha and beta waves. For a buy-and-hold investor, however, there is plenty to be said for simply planning your portfolio strategy and buying investments accordingly, preferably after a good night's sleep and when properly fed and hydrated.

The best traders may well be highly numerate individuals whose cognitive function enables them to process complex information effectively, but they are still constrained by time. This means, inevitably, they are going to rely on heuristics; taking mental short-cuts to reach the best decision they can, when often a snap judgment must be made. Heuristics aren't necessarily a bad thing and humans evolved to make fast choices and adapt to environments when knowledge was incomplete. Short cuts, however, often lead to inefficient allocations of capital and the biases of traders have a material effect on market price levels.

 

Do you trust your memory?

Dr Sharot and other UCL scientists including Professor Peter Dayan and Professor Ray Dolan, have undertaken research into the role memory plays in formulating our view of the future. Their work has led them to consider some interesting possibilities. For instance, it may be that the neural systems responsible for remembering the past have not evolved primarily for accuracy. This means that recording is not the primary task of memory; rather it is to shape our future perceptions.

Professors Dayan and Dolan were recently awarded the 2017 Brain Prize for their research into how the brain recognises and processes reward. The applications of this work will be in analysing decision-making, gambling, drug addiction, compulsive behaviour and schizophrenia and there are also implications for investors. Building on the discovery that there is a discrepancy between the level of dopamine transmitted in anticipation and enjoyment of rewards, they discovered that the brain learns to revise predictions depending on how much it enjoyed the previous reward.

It would be interesting to see how this ties up with behavioural finance and the prospect theory of Kahneman and Tversky, which focuses on how people use heuristics to order potential outcomes and then how they evaluate and respond to actual results. Some studies have suggested that losses are twice as psychologically powerful as gains and therefore are considered more when framing future actions. How this tallies with our optimism bias isn't yet clear, but perhaps positivity is evident in the way investors convince themselves that they weren't to blame for poor decisions.

However we remember or rationalise the reasons for successes and losses, one of the smartest things we can do in portfolio planning is to start out by acknowledging that we are going to make mistakes - we don't know what they will be, but they will happen. Our brains are amazing, but we are a long way from understanding fully how they work. The best rule of thumb for now is probably to remember that due to the patterns of our evolution and the very sophistication of our neurological wiring, none of us are as smart as we think we are.

 

Optimism bias in humans

  

To demonstrate the way our brains work to instil the optimism bias, Dr Sharot and her team measured the percentage of bias control subjects had towards positive interpretation of information. Generally, they found that subjects who weren't interfered with learned about 4 per cent more from good news, relative to bad news. Then using magnetic waves to interfere with the parts of the brain that help us process positive and negative information, they found it was possible to eliminate or accentuate the optimism bias. If the left inferior frontal gyrus (the part of the brain that registers positive information) was impaired then the optimism bias disappeared and subjects learned 2 per cent more, relatively, from bad news. If the right inferior frontal gyrus (which registers negative information) was impaired, the optimism bias became even more pronounced.