This Is Your Brain On Stocks

By Andrew Beattie AAA

In 2004, Brian Knutson, an associate professor of psychology and neuroscience at StanfordUniversity, discovered that trading stocks tweaked the same part of the human brain that was associated with sexual lust and drug abuse. This neural network, usually called the "pleasure center," fires up in anticipation of rewards and can dull or even override the frontal lobe, the place where neuroscientists believe most of our reasoning is carried out. Does this mean stockbrokers will start appearing in "most wanted" posters and be reduced to pushing tech stocks in dark alleys? Not likely, but it does highlight some interesting psychological issues that investing brings out in otherwise sane people.

The Not-So-Rational Investor
In the 18th century, English philosopher Jeremy Bentham stated that man is ruled by two motivations: the pursuit of pleasure and the avoidance of pain. Knutson's tests have shown that investors are subject to similar motives.

According to Knutson's experiments, investors tend to act rationally until an event causes them pleasure (above-average gain) or pain (a loss). He asked participants in his study to choose from three investments - a low-risk bond and two stocks of variable risk and reward - to "invest" in a set market. The bond paid out a guaranteed $1; one of the stocks had a 50% chance of paying out $10 per trading round and a 25% chance of losing $10; the other stocks had a 50% chance of losing $10 and a 25% chance of gaining $10. The participants knew the stocks would have varying payouts, but they didn't know which stock was which. Basically, they had to judge the stocks by the results in each round of trading, and on the overall history as the experiment continued - much like trading in an emerging market for which little information is available.

Most participants started out making rational trades; the rational, pleasure and pain centers of the brain were most active, but the rational center was dominant. After an unexpected gain or loss, however, the pleasure and pain centers became more dominant and increased the probability of the subject making an irrational decision. A setback prompted risk-averse behavior and a gain prompted risk-seeking behavior, both of which increased the chances of losses - either through overly conservative decisions (bonds all the way), or overly reckless ones (continually betting on the high-risk stocks). These two different parts of the brain were essentially overpowering the seat of rationality, resulting in a tug-of-war between the two extremes (risk aversion and risk taking).

These findings help explain some of the behavioral investing problems that economists have recognized over the years. Brain chemistry is partly to blame when we chase last year's gains too long and miss selling at a profit, take losses to heart and over-liquidate a portfolio instead of value averaging, or make any of the other costly decisions that prove us to be not-so-rational investors. Rationality, it turns out, is the norm, but periods of irrationality can develop as suddenly as a tropical storm.

Trading for Trading's Sake
The main issue brought up by Knutson's findings is the addictive nature of trading as an activity, separate from the realization of losses or gains. It has long been thought that people seek money as a means to other things - faster cars, bigger houses, fuller closets - but the results of the study suggest that money itself, or rather, the act of accumulating money, may be the reward. Knutson found that rapid trading itself - the deluge of information requiring quick decisions - can actually force a person's mind into a state in which he or she will naturally make more mistakes. (In Knutson's study, the participants were not allowed to make only a single decision and sit out the rest of the study as a value investor would.)

This is bad news for investors, because there is a cost of trading, beyond losses and gains - that of commissions. If trading becomes a hobby that you're willing to do for the "high" or thrill of it, then you can expect to pay for it. If making money is your goal, then rapid trading holds the double pitfall of chemically priming your brain for failure and costing a bundle in commissions.

The Advantage of Experience
In another study about investor behavior, it was found that mistakes do truly plague the young and inexperienced. In a 2004 MIT study of trader performance (Fear and Greed in Financial Markets: A Clinical Study of Day Traders), the researchers found that inexperienced traders were much more prone to emotional mistakes than experienced traders were. This suggests that traders have a good chance of making rational (and hopefully profitable) trades if they're willing to put in the time needed to dull the psychological highs and lows that come with trading. Just as doctors become desensitized to blood and racecar drivers become desensitized to speed, traders can overcome the emotional factors connected to making and losing money that would otherwise dull their edge.

For the Brave and Bold
Trading can be a sport for those who have the stomach for it, but casual investors shouldn't jump into day trading with their retirement savings. You wouldn't attempt heart surgery on a friend or drive 160 mph without training, and you should avoid day trading unless you're in it for the long haul and willing to sit through the learning curve.

The Bottom Line
Even if you're not interested in day trading, Knutson's study holds importance. Any stock investing, even value investing, is trading - it's just spread over a longer period. By taking your time on financial decisions and giving your rational mind time to reassert itself, you stand a good chance of reducing the behavioral errors that will hurt your portfolio.

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