The Sum of All Fears: Are Investment Impulsiveness and Risk Aversion All in the Mind?

The Sum of All Fears: Are Investment Impulsiveness and Risk Aversion All in the Mind?

When markets become erratic, it’s usually a sign that emotion is driving decisionmaking. Two classic studies suggest that what in turn may drive emotion-based trading is a structure in the brain which controls fear, and another which seeks reward.

Why is this important to the investor? Understanding why others are making investment decisions that may seem irrational can help an investor avoid the deep troughs of fear, as well as unsustainable bubbles. This has never been more true than in recent weeks, as markets have soared or swooned based on emotion-centered beliefs, misperceptions, and even generous measures of wishful thinking.

As Warren Buffet has famously advised, “Be fearful when others are greedy, and be greedy when others are fearful.”

It’s not only economists and psychologists who are studying this type of investment behavior, but also neuroscientists. Using such tools as MRIs, they explore on a molecular level how individuals make decisions — and why those decisions are sometimes puzzling.

In the first study, researchers at the California Institute of Technology examined the reactions of two patients who had been born with damage to a structure of the brain known as the amygdala.

Presented with opportunities to bet money or keep the cash, the two invariably chose to bet. This was true with even the riskiest bets presented. Participants in a control group were much more cautious.

The two patients cannot feel fear, and in fact cannot even recognize the emotion of fear in facial expressions. Clearly, this eliminated fundamental barriers to unwise financial decisions. When functioning normally, the brain’s fear center apparently makes individuals afraid to lose money.

“Loss aversion has been observed in many economic studies, from monkeys trading tokens for food to people on high-stakes game shows, but this is the first clear evidence of a special brain structure that is responsible for fear of such losses,” said Colin Camerer, a member of the research team.

At the other end of the spectrum, a team of Japanese researchers found that greed is influenced by the striatum, which the report described as a “major reward-related brain structure.”

Winning a financial reward increased activity in this area, but so did the simple possibility of monetary gain. The higher the risk, the greater the amount of activity in the striatum.

Does this mean that emotion has no place in prudent investment decision-making? An earlier study suggests emotion is a component of rational decisions, too.

Researchers at Stanford University found that the same “excitement” and “fear” centers of the brain which lit up on MRIs just before test subjects made irrational decisions, also showed activity when prudent decisions were being made. The difference was in the intensity of the brain activity.

For the neuroscientist, fear and greed in the markets are as normal as pain and pleasure in the brain. Knowing that, an investor may gain greater ability to identify irrational group behavior and market excess.

Important information about mutual funds is found in the Fund Facts document. Please read this carefully before investing. Commissions, trailing commissions, management fees and expenses all may be associated with mutual fund investments. Mutual funds are not guaranteed, their values change frequently and past performance may not be repeated. Unit values and investment returns will fluctuate.

Insurance products, including segregated fund policies, are offered through Beyond Business Financial Solutions Inc., and Investment Representative Nathan Garries offers mutual funds and referral arrangements through Quadrus Investment Services Ltd.