- Behavioral finance is one of the hottest topics on investors' minds today.
- While advances in knowledge of the brain's inner workings are highly valuable, misinterpreting scientific results can have extremely detrimental effects to portfolios.
The brain (according to many academics) is the new frontier of knowledge. With huge advances in technology and big research budgets, we know more about the brain today than ever before—and the information explosion is only accelerating.
Many see today's renaissance in brain studies as the single most important breakthrough for science and social science in decades. Biologists have become neurobiologists; philosophers are neuro-philosophers; even literary types are traversing new frontiers by using cognitive psychology to study how brains understand stories!
But one of the hottest new topics in the wake of all this new brain matter is the field of investing—referred to as behavioral finance. Memory, instinct, emotion, consciousness, hormonal responses, the limbic system, the pre-frontal cortex, cerebellums and hippocampi—how do all these affect our investment decisions and the markets?
For some time brain mechanics have been on the minds of academic economists, but now it's hit the mainstream—a hot topic for even the armchair investor. Bookstores and periodicals are starting to feature topics on the brain's inner workings and what it means for portfolios in droves. But be warned—much of it's drivel.
There's little doubt neuroscience is a great (if not vital) tool for successful investors today. The revelation that markets are in fact irrational at times, and further, folks often act in discord with their goals because of natural neural wiring, is nothing short of a revolution in thought.
But like any tool, neuroscience can pose a danger to portfolios if not understood properly. We've recently noticed a spate of articles touting a behavioral approach to investing, but often getting the conclusions wrong.
Except in One Career, Our Brains Seem Built for Optimism
Robert Lee Hotz, The Wall Street Journal
There's nothing really incorrect with this article's information, which cites evidence the brain is wired for optimism. In fact, it's highly useful for investors to know optimism and hope are widely considered to be components of a healthy psyche. That tells us a lot about how we view our investing prospects.
Or…does it? The problem is trying to use this information without the proper perspective could completely derail your investment outlook. For instance, if we take it as fact that folks are too optimistic most of the time, then it would follow that general investor sentiment, and perhaps even the media's outlook for the economy, should also be overly optimistic most of the time too, yes?
But the opposite is true! Individuals have a tendency to be overly optimistic about their personal situations—not the world around them. In fact, we have an innate tendency to be overly dour about the world around us.
Overconfidence and fear are both extremely potent evolutionary strategies. We are overconfident about ourselves because the psyche needs to shun failure and believe it can succeed, even after it fails or faces danger. This was particularly true in the Stone Age when humans needed protein but to get it had to grapple with giant predators and often kill them to do it. Chicken Little would never survive the wild. We need Conan.
Conversely, we're naturally pessimistic about the world around us because fear keeps us alive. Being at ease means a predator could come at any time and eat you, so we're hard-wired to always be on our toes and watchful. Therefore, when thinking about the world around us, we often have a natural pessimistic bias.
Making that one minor miscalculation (mistaking personal optimism bias for communal pessimism), one could easily say, "Everyone's too optimistic! I should sell my stocks now!" That could derail your whole investment strategy and put you on the wrong side of the market very often.
The real problem with neuroscience is what it's proven so far is mostly done by experiment. Isn't that a good thing? Shouldn't all things be proven by experiment and scientific method?
Well, yes and no. Experiments have a big flaw when it comes to extrapolating their results to real life: Isolation of variables. A true, rigorous experiment mitigates as many variables as possible to examine a single factor. But the real world works nothing like that. Our worlds are multi-variable, unique-to-each-person existences with all sorts of demands and stimuli influencing our decisions. That makes experimental findings good guidelines, but often extremely poor real world guides.
So tread lightly—while neuroscience and the continued development of evolutionary biology are quickly becoming essential to contemporary knowledge across disciplines, there are big pitfalls if misunderstood.
Brain science, like brains themselves, should be used wisely, or probably not at all.
Have a great weekend.