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Mind Over Money

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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.

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.

You suggest that advisors should re-consider the risk-tolerance portion of their client questionnaires. Please talk about that.People don’t really have something called risk tolerance in the way that regulators mean it. For any investor, risk tolerance is a function of the situation, the emotion you’re feeling, what mood you’ve been in all day, physical condition, [etc.]

The conventional way to ask people about risk tolerance does not work. It’s pretty much intellectual fraud. People don’t know what their risk tolerance is. Asking questions like, “What time would you arrive at the airport for a 1 p.m. flight?” is [nonsense] because the attitude people have toward risk in one area of their lives does not carry over.

So it’s better to ask clients what their objectives are rather than how much risk they think they’re comfortable with — because they don’t know.

As part of your research, you visited labs and underwent brain-scan experiments. What did you learn when you sucked on a Kool-Aid-supplying pacifier while trying to choose the square that would earn you the most money?It showed me the power of unconscious thinking. There was the so-called rational part of my brain struggling to figure out what square to pick next for the more profitable choice. But the unconscious, intuitive part of my brain was saying, “All the sugar-water is over here!”

Actually, we make most of our decisions in life without thinking about them even when we think we’re thinking about them. There is no doubt that the investment behavior of both advisors and clients is driven by these same unconscious likes and dislikes.

Such as?A client may once have had a great vacation in Montana and has a portfolio with a bunch of stocks that do a lot of business in Montana. They may not even know that’s why they have them. But if you try to get the client to sell, they won’t want to — and won’t know why. This is another reminder that advisors have to ask a lot of questions.

You write that pushing back with your forearm from a hard surface, like a desk, helps you think less emotionally. Please explain!It’s an amazing finding. Your body gives you signals. If you assume an approaching posture, that’s a physically welcoming stance. But if you push away and distance yourself from the emotional aspects of a decision, you’re putting your body in an avoidance stance. So that stiff-arming motion sends an unconscious signal to your [brain] that something may not be perfectly pleasant — and to think twice, for instance, before you make a move in the market.

Is there a related phenomenon regarding clients?Yes, how easy or difficult things are to understand also sends a signal. For example, when investors read stock and mutual fund prospectuses with numerous pages of disclosure about every conceivable risk, what happens in their minds is a huge backfire effect. They think, “I can’t believe how much stuff is here, and I can’t understand any of it.”

How can advisors use this finding?The very important lesson is that if you want clients to accept something readily, make it simple, clear and compelling. If you want to turn people away from something, give them mountains of documentation. It will make them feel: this is too hard to understand, so it can’t be very good.

You write that stocks earn slightly higher returns on days when the sun is shining than when the sky is overcast. Come on!I don’t think you can trade on that, but it’s a very important reminder that emotions have significant effects on people. I’m pretty sure that within the English stock market, on average, they do better on sunny days.

Also, in countries where people are obsessed with soccer, the stock market does better when the national team advances in the World Cup and worse when it’s defeated in a game.

What all this tells us is that people are not able to separate emotion in one area of their lives from decisions in another.

What can financial advisors do to try to prevent this from occurring when it comes to clients’ emotions?An advisor who has a long-term perspective has to make sure that everything in their office is in accord with that principle. If you’re talking to a client about holding stocks and mutual funds for five years or longer and there’s a Bloomberg terminal on your desk or CNBC playing in the background, you’ve blown it.

When advising clients for the long term, everything should evoke patience. You shouldn’t be a fast talker. Any sorts of beeping, blinking, buzzing, twitching, moving things should be nowhere near your client. Your office should have thick carpeting. So if you use a Bloomberg, put it in a closet.

Why do you recommend that advisors save the best news for the end of a face-to-face client meeting?Psychology and neuroscience have found that human memory fixates on the peak experience and how it ends. There have been studies: People were given a painful medical procedure. After that, they had the same procedure; but it lasted longer and was more painful for the final five minutes. Then the intensity of the pain eased up. The subjects preferred the longer procedure because it ended better.

If you’re meeting with clients, you definitely want to end on a high note because if you put the best at the end, you increase the odds that that’s what they’ll walk away with.

A lot of advisors have a tendency to start meetings with the good news. Instead, what neuroeconomics tells us is to get the bad news out of the way first and end on the high note.

Freelance writer Jane Wollman Rusoff is a Los Angeles-based contributing editor of Research and is the founder of Family Star Productions.


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