You know why economists rarely get it right? Because you and I are constantly letting them down with the decisions we make. Every time we buy something on impulse, we drive them up a tree.
They’re beginning to get it, though.
Economists used to think we act rationally. That every time we save, spend, or invest, we dispassionately size up the pertinent information and circumstances and make a clear-headed decision.
What a hoot. Most of them now acknowledge we’re not as rational as their theories have made us out to be.
Now a new bunch is saying investors are greedy, stupid, fearful, emotional, and short-sighted. Don’t worry. I’m going to tell you what you can do about it. But first, let me tell you who these nervy economists are.
In 1997, a group of neuroscientists and psychologists held a two-day conference in Pittsburgh and gave presentations to about 20 economists. What came of this was a new way to look at economics. They called it “neuroeconomics.”
My daughter is a neurology major at Dickinson College in Pennsylvania. She studies how the brain works. Neuroeconomics goes a step further. Using the latest imaging technology, scientists look at the brainwaves we produce when we make economic decisions.
A recent article in The New Yorker examined some of the experiments conducted by these “neuroeconomists.” In one study, a group of respondents were put in MRI machines and given “take-it-or-leave-it” ultimatums – offers to split various amounts of money between them and another party. Even though getting a little of something is better than getting nothing at all, the stingier offers ignited brain activity in the limbic structure (the part of the brain that’s responsible for anger and distress). The more activity in this part of the brain, the more likely it was that the offer would be rejected.
The conclusion? Emotion trumps reason.
Another experiment looked at what happens in our brains when we are faced with the choice between an immediate reward versus a delayed reward. Volunteers were given two choices: an Amazon.com gift card worth $15 for immediate use or a $20 gift card that couldn’t be used for another month. The scans showed brain activity in both the reasoning part of the brain (lateral prefrontal) as well as the part of the brain responsible for anger and distress (limbic). The greater the activity in the limbic areas, the greater the chances that the gift voucher for immediate use would be chosen.
Behavioral economists have known for a good 10 years that we act on preferences grounded in something other than reason. Now we know why. Different parts of the brain compete with each other. And when the emotional parts of the brain get stimulated (for whatever reason), our decisions are more likely to be emotional. And this can result in lower benefits or higher risk over the long run.
For example, when people are presented with a 50 percent chance of making $150 or losing $100, most don’t bite. But in an experiment with patients who had lesions on one of the three regions of the brain that are responsible for regulating emotions, these bets were accepted more than 80 percent of the time. Take away the fear of loss, and the brain usually makes the logical choice.
So what can you do to tame the emotional side of your brain?
1. Know thyself.
You don’t have to squeeze into an MRI machine to learn how emotional you are. If you are risk averse … if you are liable to lose sleep at night at the first sign of price slippage … don’t invest in volatile vehicles (like commodities, for example).
2. Make it as inconvenient as possible to allow your emotions to dictate your actions.
One way is to strictly follow sell-stop points.
The brain-scanning experiments I told you about indicate that the brain doesn’t like ambiguous situations. And what could be more uncertain than how much an investment will rise or fall? So we become fearful – which leads to selling our positions too early or too late.
That’s why I recommend setting 20 percent trailing sell-stops on your stock investments. This lets you ride your winners as long as reasonably possible, and provides a point at which you will exit, no questions asked.
A good way to do this is with TradeStops.com, an easy-to-use online service that will help you track your trailing stops (and a whole lot more).
3. Know thy investment.
Those experiments also show that the more you know about an investment, the less your emotions will drive decisions.
I hate it when investors put their money in something because of what they heard over cocktails. If you research the car you buy, shouldn’t you also do homework on your $200,000 portfolio? It’s your money. You need to know the risks, the upside, the growth drivers of your investment, etc. And if doing this research is yet another way to circumvent your emotional side, so much the better.
Investing isn’t about conquering your emotions. It’s about handling them. If you have a handle on your emotions without using any of the above tools (or other tools of your choosing), you’re the rare investor indeed. As for the rest of us, letting our money management and investment tools guide and control our financial decisions is a necessary step toward successful investing.[Ed. Note: Andrew Gordon is Editor-in-Chief of ETR’s investing services: Income and The Wealth Advantage He is also a regular contributor to our Investor’s Daily Edge newsletter.]