Mind Over Money

In Your Money and Your Brain: How the New Science of Neuroeconomics Can Help Make You Rich (Simon & Schuster), author Jason Zweig, a senior writer at Money magazine, offers new explanations about what makes the investing brain a battleground between emotion and reason.

His book is not only an enlightening account of what goes on in the brain when you think about money but a practical guide on how investors can make wiser decisions.

We spoke with Zweig, now collaborating on a book with Nobel Prize-winning psychologist Daniel Kahneman, to learn the ways in which financial advisors can apply neuroeconomics in their practices.

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Can neuroeconomics help make advisors better investors?It can certainly help you understand clients better. You can also use it as a mirror to ask yourself, “What am I actually good at?” Most people aren’t as good at most things as they believe they are. We all have an inner con man who lies to us about our past, our future and even the present.

How can neuroeconomics be used to help prevent investors’ hindsight bias — distorting that which you formerly believed?Both advisors and clients are very vulnerable to hindsight bias, another cruel trick your inner con man plays on you. So once a year, have a little forecasting session with each client asking where they think the Dow will be a year from now, what the most promising stocks are, what they think the worst ones will be and so on. You should do a forecast as well.

A year later, when a client starts yelling [about a poorly performing stock], you can say, “Well, let’s look at what each of us forecast. You didn’t say anything about that particular stock.”

The client will still say, “It’s your job to know what’s going to happen.” But then you should say, “It’s my job to make forecasts about things that I think are forecastable. Which specific companies [will] outperform the market may not be one of them.”

Are advisors’ brains different from the brains of investors who aren’t professionals?I’m very sad to say that I think they don’t differ. Overconfidence is probably the thing that trips up more people than anything else. It’s very hard for professionals who have real expertise to admit the limits of that expertise. Financial advisors may provide great advice on the mechanics of investing and financial planning, but I’m very skeptical that most advisors can add value by picking stocks or mutual funds.

You write that “the neural activity of someone whose investments are making money is indistinguishable from that of someone high on cocaine.” So this goes for advisors too?There’s no doubt that professionals are as subject to these kinds of influences. It’s a myth that advisors are more rational or logical or less emotional than clients. If you’re an advisor who picked a mutual fund that turns out to be the top performing fund in America three years in a row and you think you can walk on water, you’re kidding yourself.

How should advisors approach investing, then?What all the research boils down to is not to make decisions but rather to follow rules and procedures and to act in accordance with policy. If you make decisions, you’re being reactive to what other people or the market is doing. If you own Intel, let’s say, and you buy more because it’s going up and you’re on a hot streak, that addiction kicks in. When it goes down, you might sell in a panic.

Instead, if one of your rules is, “I won’t have more than 10 percent of my client’s portfolio in any one stock,” and now Intel is 13 percent, you must sell it. You have to do it automatically. The more procedures you put in place, the fewer decisions you have to make, the fewer things you have to justify to clients and the fewer mistakes you’ll make.

You caution against advisors’ “jackpot jargon” and FAs shoving charts in front of them; you tell readers to hang up on cold callers and to pump advisors as to why they recommend a certain investment. Do you feel FAs are on the take?I hope people don’t get that impression. The advice element of the advisory relationship is so important and can be really helpful to the investor. Where I have my doubts is about stock- and fund-picking. Evidence would suggest that advisors are not better enough at picking mutual funds to warrant the fee they get just for picking them.

So I urge advisors to spend more time hand-holding and less time portfolio-building because that’s not really where they add value.

You say neuroeconomics shows that the brain is more aroused when you’re anticipating an investment profit than when you actually get one. What a bummer!This new idea tells us that expecting an outcome is emotionally much more intense than experiencing the same outcome. And that’s true both on the upside and the downside. The fear of loss usually turns out to be worse than the actual loss, which is why so many clients take less risk than they should.

What this tells you as an advisor is that it’s so important to manage people’s expectations.

What if anticipation about an investment outcome generates wild excitement in an advisor?A simple solution is to keep an emotional journal. Once a day, religiously, make a little note about your gut feelings as to where the financial markets are headed, such as, “How do I feel about my portfolios today? I’m really happy about how things went. It makes me feel good.”

Every once in a while, take a look at what your emotions were telling you and what happened afterward. You’ll learn that if you turn them upside-down, your own emotions are a very good guide to what’s about to happen in the markets.

I don’t believe that investors or advisors can turn their emotions off. But I do believe you can learn to turn them inside-out. The way you do that is by seeing how unreliable they are.

This will enable you to cure your hindsight bias and to learn that by investing in the grip of emotion, you will always get things backwards.