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Financial Decision Making Comes From Deep Inside the Brain

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Why are some people better investors than others? Why are some investors bigger risk takers than others?

Research in the emerging field of neuroeconomics has shown that the answers to these questions lie deep inside the human brain. Investment decisions — the amount of risk a person is willing (or unwilling) to put into their portfolio, for instance — is in large part determined by an individual’s emotional state, and those emotions are generated by different parts of the brain.

“There are two parts of the brain that deal with emotional processing,” says Camelia Kuhnen, associate professor of finance at the University of North Carolina. “One is the ‘reward’ part, which is responsible for emotional states like excitement, and it activates automatically when it recognizes good things in the environment. We found that for whatever reason, when people have more activation in this part of the brain, they are more willing to take on risk.”

Conversely, if environmental stimuli activate the part of the brain that’s responsible for creating anxiety, then people are less willing to take on risk.

“Our research has shown that the brain is very much involved in the generation of emotional states and even for reasons that might have nothing to do with financial action, these states still drive the amount of risk that someone is willing to put in their portfolio,” Kuhnen says.

This is just one facet of what actually drives financial decision making, she says. As neuroeconomics – which uses a brain scanner to study how economic decisions are made inside the brain – evolves, it’s becoming increasingly clear that financial decisions come from deep within, and are complex and multi-layered. While behavioral finance has shown that humans are guided by emotions that influence their decisions, neuroeconomics provides deeper insight into the mechanisms that create those emotions, and shows that the behavioral deviations that influence financial decisions has much to do with how an individual’s brain works.

While a primal response to environmental stimuli seems to determine financial decisions and risk appetite — even when a person isn’t thinking about anything financial — the work done by Kuhnen and other neuroeconomists has shown that there are a number of other factors that enable people to control their emotional states. This emotional regulation makes some people better investors than others.

Greater experience with financial markets, for instance, can make a difference to financial behavior.

“With experience, your emotional reactions become less powerful,” Kuhnen says. “If an investor has confronted unusual market events on a regular basis, then they’re more likely to be able to regulate and control their emotions, and so these become less important for their behavior in the marketplace.”

Those who have a better understanding of the people around them and how others operate, who possess what Kuhnen calls “a theory of mind” skill, also make for savvier investors. Although conventional wisdom would purport that individuals with strong quantitative skills understand financial concepts and markets better than those who don’t have these, neuroeconomics research has shown that “it’s not just your ability to understand numbers that determines your success as an investor.”

“Those who do well are those who understand that there are others around them who have their own intentions and strategies,” Kuhnen says.

Some of us are better than others at guessing what’s in other people’s minds, so there is some variation in theory of mind skills. However, studies have shown that individuals with more developed theory of mind skills achieve better financial outcomes.

Finally, the way investors process information about what’s going on in the market is another differentiator, and this is an area that Kuhnen is currently working on.

Logically, investors should be taking in any new information, positive or negative, about stocks that they own, but this isn’t the case. Kuhnen’s investigations have shown that investors pay more attention to positive news about a particular stock that they own and less attention to the bad news on those stocks. Those who don’t own a particular stock will pay more attention to negative news about that stock because they don’t own it, as this reaffirms their decision to not own that stock.

“This shows that we don’t all learn the same way and what we have in our portfolio shapes the way in which we learn and the information we pay attention to,” she says. “It’s important, though, for investors to pay attention to everything that happens to their investments. This is something that a financial advisor can help with by providing an objective viewpoint.”

Kuhnen received her Ph.D. in finance from the Stanford Graduate School of Business, and two bachelor’s degrees (in finance and neuroscience) from MIT. She is the president of the Society for Neuroeconomics.