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.