What makes financial markets is you. Yes, you and millions of other emotionally driven investors buying and selling to try to find profits. Markets go up and down, but as long as you keep a clear head, you’ll be fine, or so a certain mindset seems to say. You may have heard this phrase before or others like it: “Just control your emotions.”
"The investor’s chief problem—and even his worst enemy—is likely to be himself."— Benjamin Graham
New findings in psychology and science have shot that mindset to pieces. When markets fluctuate, humans have unavoidable physiological responses. There are two fields of study that give us further insight to better understand how an investor responds to market fluctuation, both to the positive and to the negative:
Applies the study of psychology to the investment process. Behavioral finance seeks to explain the role of emotions in investors’ actions.
Examines your cognitive reactions to investment decisions and how they will affect your long-term portfolio performance.
Economists have for a long time assumed that people are rational when given the same information about risk preferences and investment capital in order to make sound decisions regarding their portfolios. But recent research has shown that people make the opposite choices as to what would seem logical and intelligent for optimal portfolio performance.
Scientists have found that humans basically have two brains. Our limbic system, or inner brain, controls our emotions, such as greed and fear. For example, we instinctively seek sources of pleasure, such as food, and we try to avoid sources of danger, such as the edge of a cliff. By contrast, our prefrontal cortex, or outer brain, controls our unique ability to organize information, compute probabilities, and plan for the future. We might assume that the outer part of the brain would be in heavy use when we make investment decisions, but that’s not how our brains work. Part of the problem is that our inner brain is the first to assess a situation or process information before it reaches the prefrontal cortex, or what some call the “reflective” part of the brain.
When the inner part of the brain is triggered in situations involving risk and reward, there is a chemical called dopamine that is released. This is even released during basic survivor functions when anticipating the reward of food we like. Unfortunately, bad behaviors, such as drugs or gambling, also trigger this chemical reaction in the same manner a positive reward does. When scientists examined the brains of people making investment-like decisions, they expected to see heavy neural activity in the outer reflective brain. Instead, their scans revealed brain activity similar to an addict about to get a hit of cocaine! This anticipation of financial reward triggers the same emotional responses as food, sex, and drugs do. No wonder people ignore probability and are lured into the hope of finding the next Facebook or Google; when the unexpected gain takes place, the intensity rises to keep them coming back for more. This is why those who buy lottery tickets keep coming back to buy more in hopes of greater wins.
Understanding how we as humans respond to making decisions around our money is the first step to becoming successful investors long term, but this is not the most important step of all. The most important step is creating an environment that not only understands your personal responses to gains and losses in the stock market, but also creates a system that will help ensure you are on the right path. This is why working with AssetLock-Equipped Advisors can help you achieve your financial goals with more peace of mind.
Neurofinance: What goes on in your head controls what goes on in your portfolio.
AssetLock® is tracking software used to monitor the performance of a client’s portfolio, and to predetermine the amount of downside the client is willing to tolerate. It is NOT an actual stop order and will NOT automatically sell the individual securities in the portfolio. Therefore, the AssetLock® value is a reference point to encourage a conversation between the advisor/firm and the client to determine if the client’s portfolio should remain unchanged, reset the AssetLock® percentage by reallocating to a different risk profile, liquidate part or all of their portfolio or opt out of AssetLock®.