Affect and
Financial Decision-Making:
How
Neuroscience Can Inform Market Participants
Richard
L. Peterson[1] and Camelia
M. Kuhnen[2]
Draft Copy: Please do not cite or distribute
This version: August 12, 2005.
Abstract
We review recent neuroscience literature
regarding the influences of moods,
attitudes, and emotions (affects) on financial
decision-making. Evidence indicates the existence of separate brain systems,
linked to affect processing, that are responsible for risk-taking and
risk-avoiding behaviors in financial settings. Excessive activation or
suppression of either of these systems can lead to errors in investment choices
and trading behaviors. We suggest ways
for market participants to become aware of the potential impact of affect on
their behavior, in order to avoid suboptimal financial decisions. We
have two overall aims in this paper: to educate financial practitioners about
the origins of emotions that can adversely impact their performance, and to
teach investors how to make better financial decisions.
1Market Psychology Consulting, San Francisco, CA. Phone: (415) 267-4880.
2Stanford Graduate School of
Business, 518 Memorial Way, #S479, Stanford, CA 94305-5015. Phone: (650)776-6830.
3Other research has examined the potential role of emotion
in decision-making (Bernheim and
Rangel, 2004; Camerer et al., 2005; Loewenstein et al., 2001). Also, economists have begun to incorporate
emotion into models of individual choice (Bernheim and Rangel, 2004; Caplin and
Leahy, 2001). This research, however, was not focused on financial choices.
I. Introduction
As shown by recent finance literature, individual investors systematically deviate from optimal trading behavior (Daniel et al., 2002; Hirshleifer, 2001; Odean, 1998). Some authors have hypothesized that affect plays a prominent role in financial decision making (Lo and Repin, 2002; Lucey and Dowling, 2005 for an excellent review), but the mechanisms by which affect biases choice remain unclear[3]. In this paper we review the finance literature and assemble evidence that affect-states influence both investor behavior and market prices. Utilizing recent findings in neuroscience, we describe the neurological basis of affective influences on financial decisions. In light of these new findings, we instruct readers in techniques for managing disruptive affects as they arise, to improve the quality of their financial choices.
Why do people buy both insurance and lottery tickets? Insurance insulates us from unanticipated financial losses, but is an investment with negative expected return. Most gambling behavior, such as buying lottery tickets, implies the acceptance of a negative expected return in the attempt to earn a larger gain. Paradoxically, we buy insurance to avoid potential losses and buy lottery tickets to pursue potential gains, yet both purchases themselves represent small expected losses. An explanation of this paradox may be derived from an understanding of the brain’s affective and motivational circuits.
Affect is defined as the subjective and immediate experience of emotion attached to ideas or mental representations of objects (Sadock, 2000). Affect often has outward manifestations including alteration in normal facial expression, voice tone, and physical posture. Positive affect indicates optimism, and the evaluation of a decision based on the potential for gain. Positive affect motivates us to continue pursuing a course of action. Negative affect indicates pessimism and the evaluation of a decision based on potential loss. Negative affect motivates us to avoid activities or situations that prompt it. Affect states give rise to characteristic cognitive and behavioral tendencies. Risk-related biases in financial judgment have been associated with affect and named the “affect heuristic” (Slovic, 2001 & Finucane et al, 2003).
Since the time of Aristotle, scientists and philosophers have loosely hypothesized the existence of two major brain functions that are fundamental to almost all human behavior - the reward approach (pleasure-seeking) and the loss avoidance (pain-avoidance) systems (Spencer, 1880). These two motivational systems can be activated or de-activated independently. When we face potential financial gains or losses, one or both of these systems may be utilized in the process of decision making. Neuroscience helps us understand the characteristics of these motivational systems and their consequences on our behavior. We will review recent empirical evidence that shows the direct link between brain activation specific to these systems, affective states, and financial decision-making.
Section II discusses the components of the reward and the loss-avoidance systems and defines affective states. Sections III and IV survey empirical findings regarding the role of affect in financial markets and on trading behavior, and section V discusses some of the personal consequences of pathological disruptions in the functionality of these systems. Section VI discusses the neurochemistry and genetics of risk-assessment. Section VII concludes by proposing ways individuals can make better financial choices by taking into account the impact of affect on their decision-making.
II. The reward and the loss-avoidance systems in decisions under risk
Perceiving a potential reward in the environment sets the brain’s reward approach system into action. Overall, the reward system coordinates the search for, evaluation of, and motivated pursuit of potential rewards. The neurons that carry information in the reward system transmit signals primarily via the neurotransmitter dopamine. The reward system lies along one of the five major dopamine pathways in the brain, the meso-limbic pathway, which extends from the ventral tegmental area (VTA) at the base of the brain, through the nucleus accumbens (NACC) in the limbic system, to the gray matter of the frontal lobes (MPFC) (Bozarth, 1994). (See Figure 1)
Figure
1:
The
major structural components of the reward system. The dopamine neuron cell bodies located in the ventral tegmental
area (VTA) have axonal extensions through the nucleus accumbens (NAcc) and into
the frontal lobes, including the medial prefrontal cortex (MPFC).
Dopamine has been called the “pleasure” chemical of the brain. People who are electrically stimulated in brain regions with high concentrations of dopamine terminals report intense feelings of well-being (Heath, 1964). The dopaminergic pathways of the reward system are activated by illicit drug use, leading to street drugs being colloquially called "dope." Dopamine activity in the reward system appears to correlate with subjective reports of positive affect (Knutson, 2001)
The brain’s loss avoidance system is less defined than the reward system. It runs through a region of the brain called the anterior insula. It appears to be mediated by serotonin and can be modulated with antidepressant medication such as selective serotonin reuptake inhibitors (SSRIs). Acute activations of the loss avoidance system lead to the subjective experience and physiological signs of anxiety (Bechara et al, 2000).
Chronic activation of the loss avoidance system is indicated by the personality trait of neuroticism (Floury et al, 2004). Neuroticism is characterized by risk aversion. The prevalence of neuroticism has been weakly associated with the short form (‘s’-allele) of the serotonin transporter gene, which leads to a decrease in serotonin sensitivity (Arnold et al, 2004). However, a significant correlation between neuroticism and the short form serotonin transporter gene alone is disputed (Willis-Owen, et al, 2005).
The insula is involved in the anticipation of aversive affective and noxious physical stimuli (Simmons et al, 2004) and in selective disgust processing (Wright et al, 2005). Paulus et al. (2003) show that insula activation is related to risk-averse decision-making. Paulus et al report that insula activation was significantly stronger when subjects selected a "risky" response versus selecting a "safe" response in an experimental task. Second, the researchers found that the degree of insula activation was related to the probability of selecting a "safe" response following a punished response. Third, the degree of insula activation was related to the subjects' degree of harm avoidance and neuroticism as measured by personality questionnaires.
The roles of the reward and loss-avoidance systems in portfolio
choices and investment errors are demonstrated by Kuhnen and Knutson (2005).
The goals of their study were first, to determine whether anticipatory brain
activity in the NAcc and anterior insula would differentially predict risk-seeking
versus risk-averse choices, and second, to examine whether activation in these
regions would influence both suboptimal and optimal choices. The study combined
a dynamic investment task with functional magnetic resonance imaging (fMRI).
The subjects’ actual investment choices during the task were compared to those
of a rational risk-neutral agent who maximizes expected profit. Suboptimal
choices were defined as deviations from this model, and included both “risk-seeking
mistakes” (in which people take risks when they should not) and “risk-aversion
mistakes” (in which people do not take risks when they should).
The Kuhnen and Knutson study finds that while NAcc activation
preceded both risky choices and risk-seeking mistakes, anterior insula activation
preceded both riskless choices and risk-aversion mistakes. These findings
are consistent with the hypothesis that NAcc activation represents gain prediction
(Knutson et al., 2001a), while anterior insula activation represents loss
prediction (Paulus et al., 2003). The results therefore indicate that above
and beyond contributing to rational choice, anticipatory neural activation
may also promote irrational choice. Thus, financial decision-making may require
a delicate balance – recruitment of distinct anticipatory mechanisms may be
necessary for taking or avoiding risks, but excessive
activation of one mechanism or the other may lead to mistakes.
Overall, these findings suggest that risk-seeking choices (such as gambling
at a casino) and risk-averse choices (such as buying insurance) may be driven
by two distinct neural mechanisms involving the NAcc and the anterior insula.
The findings are consistent with the notion that activation in the NAcc and
the anterior insula respectively index positive and negative anticipatory
affective states, and that activating one of these two regions can lead to
a shift in risk preferences. This may explain why casinos surround their guests
with reward cues (i.e., inexpensive food, free liquor, surprise gifts, potential
jackpot prizes) -- anticipation of rewards activates the NAcc, which may lead
to an increase in the likelihood of individuals switching from risk-averse
to risk-seeking behavior. These findings may also explain why the advertising
campaigns of insurance companies contain vivid and painful images (such as
home fires and vehicle accidents) – these activate the insula, which may cause
customers to become more risk-averse and thus more likely to buy insurance
products for self-protection.
III. Affect in Market Pricing
In the past five years, several finance studies have directly identified affective factors as likely causes of market price anomalies. Cloud cover can be used as a proxy for negative affect-states (Schwartz and Clore, 1983). Hirshleifer and Shumway (2002) found that cloud cover in the city of a country’s major stock exchange is negatively correlated with daily stock index returns in 18 of 26 national exchanges for the period of 1982 – 1997. In New York City, there was a 24.8% annual return for all days forecast to be perfectly sunny, while a 8.7% average return occurred on cloudy days. The authors cite psychology literature indicating that sunshine increases market participants’ positive affect, and may thus collectively increase their willingness to accept risk.
Kamstra, Kramer, and Levi (2001) find that stock returns are significantly related to season. They examined stock returns during the three months between the fall equinox and the winter solstice and the three months between the winter solstice and the spring equinox. The authors found that deterministic variations in the length of day contribute to stock returns. In particular, the market underperformed in the fall quarter and outperformed in the spring quarter. They hypothesized that affective shifts, such as occur in the seasonal mood variations of seasonal affective disorder, alter risk preferences and subsequent investment behavior.
Krivelyova and Robotti (2003) correlated strong geo-magnetic storms with world stock market underperformance during the following six days. The authors noted that the psychology literature demonstrates a correlation between geo-magnetic storms and signs of depression in the general population over the two weeks following the storms. Depression is an affective disorder characterized, in part, by risk aversion.
Seasonal and meteorological factors may contribute to market price anomalies via collective changes in affect (and thus risk preferences) according to the above literature. However, the nature of these effects is still debated. Lo et al (2005) cite literature that disputes the assumption that positive affect, induced by sunshine, leads to a greater willingness to take risk. Isen et al performed several experiments in which induced positive affect led to relative risk aversion (1988). Isen et al theorized that people in positive affect states want to avoid disappointment, so they are more likely to avoid risky gambles. Goetzmann and Zhu (2002) analyzed trading accounts of 79,995 investors from 1991 to 1996, and they found that individual investors do not trade differently on sunny days versus cloudy days. However, the authors found that market maker behavior was significantly impacted by the degree of cloud cover: wider bid/ask spreads on cloudy days were hypothesized to represent risk aversion among market makers.
If affect-states do predict market price movements, is there a way of measuring investors’ average affect in order to predict market prices? In the finance literature, sentiment is the closest available measure to investor affect. Both newsletter writers (Clarke and Statman, 1998) and individual investors (Fisher and Statman, 2000) show increased optimism about future stock market gains (bullishness) following high recent returns. Additionally, as the S&P 500 declined over a 12 month period, investor optimism about the stock market’s future declined in tandem with prices (Fisher and Statman, 2000).
Fisher and Statman (2000) noted that the percentage of investors who believed the market was overvalued was paradoxically correlated with expectations of future returns from 1998 to 2001. When investors perceived the market as undervalued, they expected to earn lower returns. As sentiment became more optimistic or pessimistic, in a positive feedback relationship with past price changes, so did expectations of future gain or loss. Additionally, sentiment levels appear to be negatively correlated with (and somewhat predictive of) future market price changes (Fisher and Statman, 2001).
Whether sentiment is a proxy for the activation of the reward system (bullishness) or the loss avoidance system (bearishness) remains unknown. Positive feelings (such as optimism) are a proxy for reward system activation, and it is very likely that the brain’s motivational systems are engaged when forecasting future stock market gains or losses.
IV. Emotions and Personality in the Trading Pit
Several researchers have been investigating the psychological origins of successful, and unsuccessful, trading. Quantifiable differences have been found between the personality traits and emotional reactivities of profitable traders versus their less successful colleagues. Personality traits represent affective-coping and impulse-control strategies that differ from individual to individual. Above, the personality trait neuroticism was discussed as a function of the loss avoidance system. The personality trait extraversion is correlated with optimism, an affect associated with reward system activation. Preliminary neuroscience evidence suggests that extraverts have more sensitive reward systems during financial gain processing (Cohen and Ranaganath, 2004).
Lo and Repin (2002) took psychophysiological measurements from ten traders during real-time intra-day trading and found that traders experienced physiological reactions during periods of market volatility. The study also showed that less experienced traders had significantly greater physiological reactivity to market volatility than their more experienced colleagues. The authors concluded, “Contrary to the common belief that emotions have no place in rational financial decision-making processes, physiological variables associated with the autonomic nervous system are highly correlated with market events even for highly experienced professional traders.”
In a subsequent study, Lo, Repin, and Steenbarger (2005) examined the trading patterns, personality characteristics, and daily affective reactions of 80 traders over 25 trading days. In part due to a market decline of 20 percent during the study period, only 33 traders of the original 80 completed the study. Lo et al concluded that personality traits are themselves not important for trading. However, they did find an inverse correlation between the strength of affective reactions and poor trading performance. Lo et al concluded: “our results show that extreme emotional responses are apparently counterproductive from the perspective of trading performance.”
The big five personality traits - extraversion, conscientiousness, neuroticism, openness, and agreeableness - are directly related to styles of affective processing and impulse-control . Fenton-O’Creevy et al (2004) concluded from a study of 118 professional traders at investment banks that successful traders tend to be emotionally stable, introverted, and open to new experiences.
Trading coach Brett Steenbarger performed personality tests on 64 traders at one of Linda Bradford Raschke's LBR seminars. He found that high conscientiousness scores (a measure of impulse control) were the most reliable predictor of trading success. Conversely, Steenbarger found that high openness and high neuroticism are correlated with trading problems (2003). He summates these findings as "one important lesson: Success in trading is related to the ability to stay consistent and plan-driven." The above researchers found that emotional stability and impulse control correlate with successful trading.
V. Financial
Decisions and Mental Health
The neural origins of financial risk-taking can be partially understood by an examination of the underlying pathologies and treatments of individuals who exhibit disordered financial behavior. Some mental illnesses, as defined by the Diagnostic and Statistical Manual IV-TR (2000), result in abnormal financial behavior. Brain lesions in the orbitofrontal cortex, which is a processing center of the reward system, have been found to result in specific abnormalities in financial decision making (Damasio, 1994 & Shiv et al, 2005). Taken together, these findings shed some light on the fundamental mechanisms of financial decision making.
Acute mania is a
pathological mood state typically characterized by euphoric mood and excessive
risk taking (including with money).
Some manic patients who have access to brokerage accounts will rapidly
trade stocks, often until the account is drained. One website notes that some manic patients “go on shopping sprees, spend food money to buy
lotto tickets, or try to make a killing in the stock market.” (Bernhardt, 2005).
Mania is caused by overactive dopaminergic circuits in the brain, including
the mesolimbic circuit of the reward system.
Treatments for mania include antipsychotic medications that directly
block or limit the neural stimulation caused by dopamine release. These treatments are often rejected by
patients because they also dampen the euphoric high that accompanies an acute
manic episode.
The lifetime prevalence of pathological gambling disorder in the United States is less than 3.5% (APA, 2000). Recent neuroimaging studies demonstrate a hypoactivity of the reward circuitry in these individuals. Pathological gamblers often gamble to “feel excitement,” which they achieve by activating their pathologically desensitized reward circuits.
Pathological gambling is often treated with Naltrexone (Kim et al, 2002), a medicine that blocks opiate receptors. In the reward system, mu opiate receptors stimulate dopamine release (DiChiara & Imperato, 1988). Blocking opiate receptors with naltrexone decreases dopamine release in the nucleus accumbens, which results in decreased subjective feelings of pleasure (Jayaram-Lindstrom, 2004). Gamblers taking naltrexone are not compelled to seek reward system stimulation through further gambling, possibly because they feel reduced pleasure from gambling.
Some subtypes of depression, such as “melancholic” depression, are correlated with decreased dopamine activity in the reward pathway. Melancholic depression is correlated with anhedonia (lack of pleasure), excessive sleepiness, and chronic risk aversion, including in the financial markets. One patient in treatment with the author for depression kept all of her assets in cash. Because of her fears of taking financial risk, she was reluctant to invest in U.S. government bonds. She was concerned that the government might default on payments to bond-holders. These thought distortions were directly related to her depressive illness and its neurochemical basis. Successful treatment with antidepressant medications was followed by small, tentative purchases of bonds and mutual funds.
The role of anxiety in biasing financial decisions is less clear-cut than for mania, pathological gambling, and depression. At higher levels, anxiety may lead to panic and the psychophysiological “fight or flight” response (e.g., “panic selling”). Whether the “fight” or the “flight” response is triggered depends upon an individual’s past experiences, personality traits, the intensity of the anxiety experienced, and learned coping strategies. Isolated mild anxiety leads to an overall reduction in risk taking behaviors.
Anxiety can lead to either impulsive overtrading or paralysis and avoidance of the markets. In scenarios where the reward system is over-activated along with the loss-avoidance system, obsessive overtrading may result. When the reward system is under-activated, paralysis and passive anxiety is present. Mild anxiety and neuroticism are correlated with a paucity of serotonin function throughout the brain (Floury et al, 2004). These disorders are often successfully reversed with serotonin-enhancing medications such as fluoxetine (Prozac).
Two mental disorders on the obsessive compulsive spectrum merit discussion. Compulsive Shopping Disorder is currently assumed to reside on the obsessive-compulsive/anxiety spectrum of disorders, but its legitimacy as an independent mental illness is still debated in psychiatry. Moderately successful treatment was achieved with the use of the SSRI antidepressant (citalopram) (Bullock and Koran, 2003). The disorder of hoarding, wherein sufferers accumulate excessive quantities of one type of good or asset, is also considered a sub-type of obsessive compulsive disorder. Currently only behavioral and psychotherapy approaches have shown success in the treatment of hoarding (Saxena & Maidment, 2004).
VI. The Neurochemistry of Risk Assessment
An article written by a psychiatrist in February 2000 was headlined “Is this market on Prozac?” The article noted that prescriptions for psychoactive drugs increased from 131 million in 1988 to 233 million in 1998. The author went on to speculate, “I would not be surprised to learn that one in four large investors has used some kind of mood-altering drug” (Nesse, 2000). Nesse remarked that some of his patients on SSRI medications “report that they become far less cautious than they were before, worrying too little about real dangers”. He wondered whether the clear disregard for risk among many investors of the time could in part be attributed to the use of common antidepressant medications.
Many executives are rumored to refer to Prozac as the “Teflon-medicine” because it allows them to look past perceived threats, decide quickly without ruminating, and remain more optimistic during stress. In the bestselling book “Listening to Prozac”, psychiatrist Peter Kramer frets about the potential use of SSRI antidepressants as “steroids for the business Olympics” (Kramer, 1993).
Knutson et al. (1998) gave normal subjects therapeutic doses of the antidepressant paroxetine (an SSRI). Knutson’s subjects experienced a reduction in threat perception and an increase in affiliative behaviors. In another study, subjects who were administered the SSRI medication citalopram showed decreased amygdala (fear-related) activations on fMRI (Del-Ben et al, 2005). These characteristics, decreased threat perception and increased social affiliation, mirror the decreased risk perception and herding of excessively bullish investors. It is as if bubble investors have partial deactivation of their brains’ loss-avoidance systems.
Amphetamines act to increase the brain’s extracellular concentration of dopamine. Neuroimaging data collected by Knutson et al (2004) suggests that amphetamines modulate dopamine signals in the NAcc area of the reward system.
Anecdotal reports indicate that time-release amphetamine-derived medications have been used by poker players to win millions of dollars in tournaments. “With Adderall [an amphetamine derivative] in my system, I am like an information sponge, able to process data from several players at once while considering my next action.” (Phillips, 2005). The author speculates that it is the increased focus and wakefulness promoted by amphetamines that aids poker playing. In his case, modulation of the reward system via amphetamine usage improves financial decision making.
Several medications directly alter risk/return perceptions in behavioral experiments. Rogers et al (2004) report that a common high blood pressure medication, in the Beta-blocker family, decreased experimental subjects’ discrimination of potential losses during a risky task. “Propranolol [a beta-blocker] produced a selective change in volunteers' decision-making; namely, it significantly reduced the discrimination between large and small possible losses when the probability of winning was relatively low and the probability of losing was high” (Rogers et al, 2004). Propranolol is also one of the most common treatments of “stage fright”, and it is occasionally used in the treatment of other types of anxiety.
THC, the active ingredient in marijuana, also affects financial decisions. When given a choice between a certain but low-value positive expected value option ($0.01) or a zero expected value option with high return variability, THC intoxicated subjects preferred the risky option significantly more than control subjects who had been administered a placebo (Lane et al, 2005a). If they lost money after selecting the risky option, THC intoxicated subjects were significantly more likely to persist with the risky selection, while controls were more likely to move to the positive expected value option (Lane et al, 2005a). Lane et al (2004) found a similar persistence with the risky option in alcohol intoxicated subjects as compared to controls. Alcohol intoxicated subjects were more likely to choose the risky option than controls (Lane et al, 2004).
Deakin et al. (2004)
showed that a dose of the benzodiazepine Valium increased the number of points
wagered in a risk-taking task only in those trials with the lowest odds of
winning but the highest potential payoff.
Lane et al (2005b) found that administration
of the benzodiazepine Alprazolam produced increased selection of a risky option
under laboratory conditions. “Additionally, risk-seeking personality traits may
be predictive of acute drug effects on risk-taking behavior” (Lane et al,
2005b).
The above studies
illustrate that common chemical compounds, both medications and drugs of abuse,
can have profound effects on an individual’s risky choice. In particular, frequently prescribed
antidepressants and anxiolytics, SSRIs, appear to decrease threat perception
and increase social affiliation.
Time-release amphetamines increase alertness and smooth the reward
system’s reactivity to potential financial gains. Common blood pressure medications, beta-blockers, decreased
aversion to potential financial losses.
Alcohol, marijuana, and benzodiazepines increase the frequency of risky
choice and decrease negative affect states following recent losses. Anecdotal reports of widespread alcohol
abuse among Wall Street traders may be related to alterations in risk
perception noted above.
VII. How to make
better financial choices
VII.A. Trading Psychology
The use of psychological techniques to improve performance in the business world is increasing rapidly (Goleman, 1998). According to Jack Schwager, author of Stock Market Wizards (2003), Steve Cohen is “unquestionably one of the world’s greatest traders”. Steve A. Cohen is the principal at SAC Capital. A former Olympic psychiatrist, Ari Kiev, M.D., is “a permanent fixture” at SAC Capital. The use of a psychiatrist by one of the world’s greatest traders supports the notion that psychological management can have a beneficial effect for financial risk takers. It may even suggest that people need psychological support to prevent themselves from succumbing to the most common cognitive, behavioral, and affective biases.
While observing Steve Cohen trade, Schwager is “struck by his casualness.” Schwager notes, “He also seemed to maintain a constant sense of humor while trading.” Cohen’s sense of humor and casualness demonstrate that he isn’t taking his trading gains and losses “to heart”. So how can the average financial decision maker maintain such an emotional balance and healthy state of mind?
One method of cultivating dispassion about financial performance is to maintain non-judgmental beliefs and flexible expectations. In particular, practitioners must not see their decisions as so weighty as to require absolute perfection. They will be inevitably disappointed in that case. George Soros provides an excellent example with his well-publicized “Belief in Falliability”. "To others, being wrong is a source of shame. To me, recognizing my mistakes is a source of pride. Once we realize that imperfect understanding is the human condition, there’s no shame in being wrong, only in failing to correct our mistakes.” (Soros, 1995).
Soros is protected from a crisis of confidence. For most people, the possibility of being wrong is threatening. It gives rise to anxiety. “The difference between Soros and most other traders is that he accepts fallibility, so he starts out by assuming his hypothesis is wrong, rather than right like almost everyone else.” (Cymbalista, 2003). By maintaining a belief in falliability, Soros remains open-minded about his positions. He minimizes denial, disappointment, and anger when he learns that his decisions were wrong.
VII.B. Investor, Heal Thyself
Financial practitioners can improve their financial decision making by learning to interpret and manage affect states. With adequate self-awareness, affect states can be reflected upon as internal signals. As seen in the literature cited above, investors’ financial decisions are most likely to suffer if the individual investor is emotionally reactive or has poor impulse control. In either case, a dysfunction of the reward or loss-avoidance systems is likely. The affect-states that arise in response to a financial decision situation are conditioned by our past experiences, the vividness of the potential consequences, innate genetic endowment, and personality (among many other factors). As demonstrated in Kuhnen and Knutson (2005), strong affects threaten to override investors’ rational decision making and should be appropriately managed for optimal performance.
In clinical psychology, there are a plethora of strategies for regulating affect-states. Use of these strategies may benefit financial practitioners who find themselves overwhelmed by affect (fear, euphoria, greed, panic, etc…) during their investment decision-making.
The first step in managing affects is to become aware of them. Biais et al (2000) found that “highly self-monitoring” traders perform better than their peers in an experimental market. While it is important to notice affect states, it is crucial to avoid placing any value judgment on them. Judgments such as “I shouldn’t be feeling this” or “I’m really good at this” further interfere with the exercise. Value judgments themselves give rise to further affective reactions (annoyance, disgust, anger, frustration, self-congratulation … to name a few).
Some common causes of affective reactions among financial decision makers include the size of the potential reward or loss being considered (Knutson et al, 2001), the vividness of potential consequences (Loewenstein et al, 2001), and counterfactual comparisons it represents (Mellers et al, 1999). Learn what financial situations cause affect to arise. Place the feelings in a context, and then practice noticing what automatic behaviors you have associated with them.
Meditation, peaceful reflection, and contemplation are disciplines used for millennia to improve self-awareness. Financial practitioners should practice noticing the thoughts, feelings, and attitudes that underlie their decision-making. They can search for patterns, relationships, and emotionality, impulsivity, or irritability in these thoughts and feelings.
In particular, observing your greed and fear when it arises, ask yourself: “What causes this? Where did it come from? What is it related to?” By placing the affective information in a personal context, you become familiar with your “triggers.” Too often, affect is left unnoticed and unattended to. When triggered, you can utilize awareness of your emotional state to generate a personal warning signal. By understanding and contextualizing your emotions, you can more easily detect potentially weak decision situations when they arise.
Self-discipline relates to how we manage our impulses. Self-discipline (a facet of the personality trait conscientiousness) is essential to interrupting the automatic flow between emotions, thoughts, and behaviors. Self-disciplined people are better able to control and channel their impulses towards goals. They can identify, and delay acting upon, their affects. Thomas Oberlechner from Webster University in Vienna mailed a survey form to 600 professional foreign exchange traders in Europe and the UK (2004). Each survey form asked traders to rank the most important characteristics for professional success out of a list of 23. Out of eight "factors" he derived from sub-groupings of the 23 characteristics, "disciplined cooperation" was ranked most highly.
Successful financial practitioners systematize as much of their decision-making process as possible. Professionals are prepared for contingencies, and they approach mistakes with curiosity, rather than the dread, fear, or denial of the novice. As Lo and Repin (2002) demonstrated, experienced professionals are less reactive to market volatility than novices, which may be due to a classical conditioning process or their internal beliefs.
The brain’s two motivational systems evaluate potential gains
and losses independently. We are likely
to experience relatively strong affects when one system is dominant, and are
prone to making irrational financial decisions. Our only clue to a personal condition of imbalanced motivational
systems lies in our affect-states. If
we learn to become self-aware of our affects, then we can perceive when one
system is out of balance. By utilizing
self-awareness, adopting Soros’ belief in falliability, exercising techniques
of affect management, and visualizing and practicing difficult decisions situations,
we can minimize the irrational and costly impact of financial emotions.
We can take action and learn to be more profitable.
Based on the research summarized above, it is apparent that recent financial gains and losses change investors’ behavior. Thus, financial market participants must be careful to monitor their own internal reactions to see how their decisions may be biased by their recent experience, and they must be careful to not let such biases affect their decision discipline. In particular, if an investor has experienced a recent loss and notes that he or she is feeling nervous and is exhibiting other signs of irrational risk avoidance behavior such as 1) hesitation in entering new positions, 2) deliberating about further potential losses, or 3) seeing more financial threats than usual, then he or she must take special care to not let that increase in anxiety affect future discipline in trading decisions. Conversely, if an investor has recently made large gains and is feeling 1) celebratory, 2) confident, and 3) dismissive of potential risks, then he or she must make sure not to focus solely upon potential returns and ignore the risk control and monitoring aspects required by his or her trading discipline when making future decisions.
Not everyone can maintain a disciplined investment strategy during the simultaneous gains or losses that accompany stock market fluctuations. Our research suggests that investors’ undisciplined decisions may be biased in such a way as to further the development of bull and bear markets in stocks. When the stock market is moving up and most people are experiencing paper gains, many will feel hypomanic, ignore risks, and overemphasize potential returns. Consequently the market risk premium will tend to decline and stocks will rise further, thereby generating further upward movement in the bull market. Conversely, when stocks are moving down and many people are incurring paper losses, many may become more anxious, emphasize the risky attributes of stock investments, increase the risk premium they require to invest in stocks, and abstain from buying, thereby allowing the decline in stock prices to continue as the bear market persists.
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