The Neuroscience of Financial Decisions

I'm Jason Zweig, author of the new book on neuroeconomics, "Your Money and Your Brain," and welcome to this forum on what goes on inside your clients' heads -- and yours -- over the course of an investing lifetime.

The biggest puzzle in finance -- and probably in financial advice, too -- is why investors find it so hard to learn from their own mistakes. I think the new science of neuroeconomics -- a hybrid of neuroscience, economics and psychology -- enables us to crack that riddle for the first time. By using the wonders of imaging technology to get down to the biological bedrock of financial decisions, neuroeconomics shows the living brain in action, isolating the circuits and systems that determine how we think about money. I've spent much of the past decade and nearly all of the past three years reading hundreds of neuroscience articles, interviewing scores of the world's pre-eminent neuroeconomists, and having my own brain scanned in nearly a dozen different labs all over the U.S. I was surprised and humbled by what I learned about the human brain and human nature. As a result, I concluded there was only one sensible way to organize the book -- around the theme of the emotions that almost every investor (and advisor) experiences over time. Among these emotions are greed, confidence, surprise, fear, regret and (of course) happiness -- each of which is the title of one of the book's chapters.

We all like to think of our brain as the powerful computer that guides us through the world's logical challenges. But it is also the heart between our ears -- a ball of emotion waiting to explode in the worst way, often at the worst time. Neuroeconomics, I believe, gives us the key to understanding how these emotions are generated and how we can control them. And it is my hope that this new understanding can enable you to reach and teach your clients better than ever before. I welcome your questions!

Jason-

Welcome to AdvisorMax, and thank you for taking time to share your thoughts on this important topic. I am excited to seek out and read your book.

How does neuroeconomics differ from the study of behavioral economics? Do they seek answers to the same questions? Is one the scientific fork of the other?

How can a typical planner best use your research in commmunicating and understanding their clients and the relationships they form?

Michael,

Neuroeconomics, as you might guess from the name, is a hybrid of neuroscience and economics, with a great deal of psychology thrown in. It takes behavioral finance down to biological bedrock, using advanced imaging technology to capture the patterns of activation in the brain, in real time, as people make financial decisions. Neuroeconomics and behavioral economics are closely related. We could say that behavioral finance is the study of what people do with their money and that neuroeconomics is the study of the brain circuitry that creates those decisions.

I'm not alone in being excited at what has already been discovered and in being on tenterhooks to see what we learn next. Daniel Kahneman, the godfather of behavioral finance, believes that the most important discoveries in the next ten years will come out of neuroeconomics.

But the insights of neuroeconomics can already be very useful to financial advisors. I'll give only a couple of examples for now.

* Let's say you have a client who categorically refuses to diversify out of his own company stock (and let's face it, he is probably a "he"!). "It's a great company," he says, "and I believe in it." You answer, "That's what the people at Enron thought" -- to which he retorts, "But they were wrong, and my company is NOTHING like Enron!" And nothing you do can get him to budge. Neuroeconomics gives us two related ideas that can crack this problem. First, the intuitive parts of the brain drive decisions when nothing gets in the way. So what you can do is simply make him think harder. The next time you raise the idea of diversifying, ask him this: "So keeping all this money in your company's stock is a no-brainer, right?" He'll say yes, of course. "Then you shouldn't have any problem giving me 12 separate reasons why it's a good idea, should you?" Immediately hand him a piece of paper and ask him to write down 12 reasons why his company's stock is the single best investment he could make. It's all but certain that he'll find it easy to think of 2 or 3 or maybe 5, but by the time he gets to 12 he will have been struggling for quite a while. This simple trick should be enough to show him that his gut feeling may not be the whole story. Then you apply the second relevant insight from neuroeconomics: familiarity. The brain is designed to prefer whatever feels most familiar. So you now can turn the tables and say, "Let me give you 12 incredibly easy and obvious reasons why you should consider adding other stocks to your portfolio. 1. Apple Computer 2. Bank of America. 3. Cisco. 4. eBay. 5. Exxon Mobil. 6. General Electric. 7. Johnson & Johnson. 8. Nestle. 9. Procter & Gamble. 10. Sony. 11. Toyota. 12. Wal-Mart." (Or use Coca-Cola, McDonalds, Nike, or any other household names you prefer. You could also simply rattle off the biggest companies in the S&P 500.) Then you add: "By keeping all your money in one company's stock, you shut yourself out of participating in the growth of all these other great companies, industries and markets. Do you really think that's wise?"

* Here's another. Every advisor has had to deal with the client who calls up screaming, "I TOLD YOU THE STOCK MARKET WAS GONNA GO DOWN AND YOU SHOULD PUT ME ALL IN CASH, AND YOU TOLD ME I WAS WRONG, AND GUESS WHAT -- YOU WERE WRONG!" There's a simple way to deal with this. Open your annual portfolio review meeting with a quick exercise. Ask your client to write down where he thinks the Dow will be a year from now, the highest and lowest the market will go during the coming year, what interest rates and inflation will be, what the best- and worst-performing industry sectors will be, what the world's best- and worst-performing markets will be. Meanwhile, you can jot down your own answers to the same questions (and, by the way, "I don't know" is a good choice). Then collect the sheets and tuck them away in the client's file (or, if you do this by e-mail, carefully archive the reply). Then, when he calls up berating you for ignoring his brainstorms, pull out the sheet and ask him to recall what he predicted the markets will do. Patiently read the true answers back to him, then explain that no one really can ever foresee exactly what the markets will do. Then tell him that your role is to help him build a portfolio that can do reasonably well over time, not all the time, and that your real job is to help him earn decent returns even when his forecasts -- and yours -- turn out to be wrong.

* Track your emotions -- and your clients' feelings, too. Chances are, your clients were pretty happy back in July, when the Dow hit 14,000 (and, according to so many market pundits, was on its way to 15,000). If you kept an emotional journal -- a basic one or two-sentence record of how you were feeling about the markets and your clients' portfolios -- you would be able to look back now and learn from your own feelings. What you would learn is that your own gut feelings are very accurate indicators of major market turns -- if you spin them around 180 degrees! When stocks are high (and becoming increasingly expensive) you are likely to be happy (instead of concerned). When they drop (and become cheaper), you are likely to be upset (instead of excited by the buying opportunities). Great investors do not turn their emotions off, but they do learn to turn them inside out. You do that by setting price targets in advance, when you and your clients alike are calm -- not by trying to count on self-control or your powers of persuasion when both you and your clients are upset. Neuroeconomics teaches us that self-control and persuasion will not work when the market goes to extremes of fear and greed. Only fools invest without rules.

So let me push back a little bit:

In each of your examples you could point to the study of human behavior, experience, or a bit of common sense in approaching the two given scenarios as you have described. In what way has the mapping of the human brain, and the analysis of the underlying circuitry, led to the development of your responses in your scenario? Will there ever be a practical application for financial planners, or will we rely on the scientists for the science and application and learn from them?

Michael,

I think applications always have to come out of thinking imaginatively about the evidence on how things work. Fundamental research -- whether it's in genetics, biotechnology, physics, or finance -- tests hypotheses with data. It's then up to others to figure out creative ways of applying the research findings to the real world. I've tried to do as much of that as I can in the book. Clever advisors will find even more ways to apply these ideas than I have spelled out.

Are these insights unique to neuroeconomics? Many of them are. For example, it's extremely valuable to know that long-term planning is processed exclusively in the reflective, cortical areas of the brain while short-term decisions are driven mainly by the more primitive emotional circuits. I think that should suggest to planners that the best way to get people to save for a long-term goal is by helping the client to visualize an intensely emotional positive scenario around the goal. The only way to excite the short-term brain is by making the long-term future feel intensely vivid in the here and now. Instead of just saying, "When do you want to retire?" you should ask "What is your dream retirement?" and then help your clients visualize that dream as concretely as possible in as many ways as you can. Saving for retirement is an abstract goal. If, instead, you create an account called the "Villa in Tuscany, April 23, 2029 Fund" -- accompanied with full-color photographs, menus, itineraries, and so on -- then you have made saving for retirement into a much more exciting motivational goal that will directly activate the reward-seeking circuitry in the brain. That's something we probably wouldn't know without neuroeconomics, and it seems to me like a very practical insight that can really help advisors boost their clients' savings.

The brain research also tells us some very interesting things about what investors are most likely to regret, how money affects happiness, why most people are so reluctant to invest abroad, and why fear is a poor motivator for older investors. Let's talk about some of those things later.

Jason

Jason,

Looking forward to reading your book. The question that interested me most from reading your forum introduction (and last response) is how neuroeconomics reveals the decisions investors are most likely to regret. What are these decisions?

And how can an advisor use this science to influence a client into making better choices, apart from working against your natural instinct?

E.W/

Ethan,

In the short run, people regret errors of commission more than errors of omission; we feel more remorse over what we did that we should not have done than what we did not do but should have done. In the long run, however, that changes: toward the end of life we look back and lament the opportunities we passed up.

This suggests to me that the old reliable approach to financial planning in retirement -- minimize risk, focus on security and comfort -- may no longer be enough. Now that the typical person will spend two or three decades in retirement (and much of those years in good health), they have a ton of time to look back and regret all the things they didn't do but feel they should have done.

Therefore, instead of merely minimizing risks, I would also focus on maximizing dreams. Retirement should not just be the time of conserving capital, but also the time when people try the things they wish they had not left undone. You can not only help them manage their money so they can afford to live out their dreams, but you can help shape those dreams. Ask your clients the questions they may be too shy to ask themselves. "If there was one thing in the whole world you always wished you could do or try or visit or experience, and you could it now, what would it be?"

I think it's very important to know that when you unexpectedly lose money on an investment, a part of your brain called the insula becomes intensely active. The insula is one of the main centers in the brain for processing disgust; the neural response of someone who has just lost money is barely distinguishable from the activation in the brain of a person who has just smelled vomit or stepped in dog doo. It's literally a sickening feeling, and it creates an almost irresistible urge to get rid of the thing that made you sick.

In my opinion, this probably explains why transaction costs tend to be higher on the sell side than the buy side -- and certainly is a warning that anyone who sells after a sharp drop in a stock's price is in the grip of intense emotion. If I had to boil all of neuroeconomics down to a single rule for long-term investors, it would be: Never make a trade until the day after you want to. That's an automatic rule that will always force both you and your client to sleep on every decision.

The other compelling thing about regret can be summed up in the old line of poetry from John Greenleaf Whittier: "For of all sad words of tongue and pen, the saddest are these: It might have been." As soon as something goes wrong, the human brain immediately begins simulating all the alternative paths the decision could have taken instead. This is called "counterfactual thinking," and the stock market generates millions of counterfactuals a day. There is *always* another stock, another fund, another industry sector, another valuation model, another asset allocation, another market somewhere in the world, that is doing better -- at this very moment -- than whichever one you chose. That gives clients an almost infinite number of ways to second-guess you and to feel intense regret over whatever decision you got them to agree to.

The best way to break this cycle is to make sure, at the outset, that you and they are on the same page about what constitutes success. How will you, and how should they, measure your performance? The other key is to invest by rule, and to make the rules explicit. If your client says, "How come we didn't have more in kumquat futures?" you need to say, "Because our policy is never to put more than XX% in a single investment, no matter how promising it may seem. Right now that may seem like a mistake, but in the long run it's the only sensible way to invest."

Jason

Jason:

Welcome. I have a question about the subjects used in such studies of financial behavior. Is it fair to presume that your book is based on "normal" or "typical" finanical reactions of the public overall? When analyzing a topic of this, of course it makes sense to look at the majority of individuals who fall in the middle of the behavioral bell curve. But humans exhibit a wide range of behavior patterns and some, we conclude, are not as well-adjusted as others. What information is available about those sub-segments who would not be considered "normal" behavior? I have a specific interest in finanical planning for individuals with special behavior needs.

For example, I have long noticed a pattern that when a client admits to being treated for depression on a long term basis, that there is little likelihood a long term satisfying relationship between the client and advisor. I usually find that I do not posess the psychological councelling skills that would be necessary to prevent the person from reverting to self-destructive behavior. In fact, this has become a topic of a private joke between my wife and I to predict which clients are on antidepressants based on a specific pattern of behavior exhibited toward their financial planning and approach to the advisor.

I also have an interest in financial planing behavior of those with special needs. Essentially this involves finding a balance between protecting the assets from the atypical behavior of the owner and allowing this legally capable adult to do as they wish with their own money. One high profile case in my area was a billionaire philanthropist who was offensive and insane for decades yet every advisor tolerated the behavior because of the wealth and the amount of community financial support. In the end he wound up in a prison hospital. It is amazing to me how many times wealthy individuals requesting professional advice turn out to be hard core addicts or have dememted criminal behaviors at the core of their values. There are also natural causes of abnormal financial behavior. My own extended family is currently dealing with two members who are having financial difficulties due to brain injury and stroke that cause swings in behavior on a day to day basis.

My casual observation is that this significant group of the population, collectively discussed here as "abnormal financial behavior types", goes from one advisor to the next, burning bridges and creating difficulties for the professional industry. They are often known as our "problem clients". We tend to lack the skills and the patience to handle them.

What are your thoughts on this topic of dealing with those known to exhibit abnormal financial behavior? Is there any specific research that expands on the patterns of abnormal behavior raised here?

Tony,

What a fascinating question!

There actually have been many studies on financial decision-making among people with addiction and severe psychological problems. People with severe depression tend *not* to be prone to overconfidence; they can make strictly realistic assessments of their own abilities, unlike the rest of us. Addicts tend to be extremely impatient, to have a distorted sense of elapsed time, and to plan as if there is no such thing as a long-term future.

It's important to realize that people who think they are investors but are, in fact, speculators -- market-timers, fast-traders, fans of Jim Cramer's TV show, the itchy-fingered folks who check their portfolio prices 12 times an hour -- probably have a mild form of addiction. The expectation of another profitable trade has set up a kind of dopamine demand within their brain. They crave the next hit of profit the same way a heroin addict hankers for the needle. I call this the "prediction addiction." If you ever identify a stock junkie among your clients, there is no point trying to change his behavior. He needs help, and you need to fire him.

There also have been many studies done of people with brain damage from stroke, blunt trauma, or war injuries. How behaviors are affected depends on which areas of the brain are damaged, and it is not a good idea to make generalizations. What I will say is that in the population as a whole, roughly four out of five people seem to be inherently loss-averse; perhaps 20% seem to have little fear of loss. Entrepreneurs, CEOs and other senior managers may come disproportionately from this pool of risk-takers. People in this group may have a touch of the psychopath in them, which may explain why CEOs can fire 5,000 people in the afternoon and then go out to a Mozart concert in the evening. It's possible that some of them, early in life, suffered mild damage to the ventromedial prefrontal cortex, one of the brain's areas for inhibiting the impulses of the more emotional circuits.

In practical terms, there's much else I can suggest. Mental illness is serious, and treating it is highly demanding. If the university hospital in your town has a good neuropsychology department, you may be able to collaborate with the researchers there to improve how you "treat" this kind of client.

Hi Jason,

Do your findings differ with client age? What does neuroeconomics tell us, if anything, about working with younger clients as opposed to older clients? For that matter, what does it tell us about working with the affluent versus "want to be" affluent?

Thanks
Erin

Erin,

Quite a lot is known about how the brain changes with age. The teen years, as anyone who has survived them knows all too well, are a time of impulsivity and immediate gratification -- along with an indifference to risk that is genuinely alarming to non-teens. Areas of the prefrontal cortex that inhibit many emotional impulses do not fully develop until around age 20, while structures like the nucleus accumbens (which is involved in anticipating future reward) mature at a younger age. Teens are constantly grabbing for whatever they want, consequences be damned, because their brains have not yet matured to the point at which the fear of risk can outweigh the hope of reward.

The 30s, 40s and 50s are the best years of our lives for making financial decisions. In a brilliant new research paper, "The Age of Reason," economist David Laibson and his colleagues look at the quality of the choices people make over the course of their lifespan. They conclude that the average person makes the best decisions around age 53, when years of experience and maturing judgment coincide; after that, there is a gradual but steady decline in how smart people are with their money. (People in their late 60s and beyond have, among other things, a troubling tendency to borrow too much money and to fall for “teaser rates” on mortgages and credit cards.) Another economist, Alok Kumar, has analyzed the investment returns of thousands of investors and notes a sudden drop-off in investment returns after age 70 [http://papers.ssrn.com/sol3/papers.cfm?abstract_id=767125].

I’ve come to think of old age as turning into a teenager all over again. The insula, a part of the brain that helps generate the emotion of disgust, actually shrinks with age; the amygdala, critical in producing feelings of fear and anger, becomes much less active. People in their 70s and 80s react much more calmly to upsetting stimuli than younger people do; a video of a car crash, or CNBC covering a stock market crash, will both be nearly impossible for a 25-year-old to tear herself away from, but a 75-year-old will merely glance at either one and then return placidly to her knitting. One study found that the amplitude of the brain waves generated by viewing upsetting photographs was roughly 50% higher among people in their 20s than it was among people in their 70s and 80s. Grandma has seen it all. Assuming her physical and mental health are fine and she has ample savings, she can almost certainly withstand more risk than conventional wisdom would suggest.

Unfortunately, along with the greater tolerance for risk comes higher impulsivity. (I don’t call old age “The Teenage Years, Part Deux,” for nothing.) Older people are motivated far more by positive than by negative emotion; the upside of anything sounds especially appealing, while the downside may not even occur to them, which is probably why get-rich-quick con artists so often target the elderly. I’d say among the best investments for aging clients (or their children) are caller ID for the phone and a heavy-duty spam filter for e-mail. It’s vital for advisors to take tighter control over risk-taking as clients move past their 70s.

Finally, you need to know that older clients “circle the emotional wagons” as they age. Research led by Laura Carstensen at Stanford shows that, past the age of 65 or so, the typical person lets casual acquaintances drop, strongly preferring to spend as much time as possible with favorite family members, close friends, and long-established contacts. Knowing they have no time to waste, the elderly become extremely selective about their own emotions; they are not interested in half-hearted encounters with people they have just met. The implications seem obvious to me: You must build a deep emotional bond with your clients long before they grow old. If you wait until they are in their 60s or beyond, they may have no interest in starting a relationship with someone they do not know well already. The time to add retirees to your client base is well before they retire. If you want to specialize in elder financial planning, market yourself to people in their 40s and 50s, not people in their 60s or beyond. Try calling it “future planning.”

To everyone who's stopped by, thanks for your time and interest. We've only just scratched the surface -- there's so much more to learn and talk about, and financial advisors themselves have a great deal they can teach behavioral scientists about how the human mind evaluates risks and rewards. I hope we've piqued your curiosity and that you now have a stake in staying current on the latest breakthroughs in neuroeconomics. I think it is the last great frontier in understanding what makes investors tick, and it can provide really powerful insights that can help you manage and communicate with clients better than ever before.

Best wishes,
Jason Zweig