It's coming any minute now. You're refreshing the investor relations page constantly, cursing your unbelievably slow WiFi, twitching in anticipation of the latest earnings report. The stock has been slipping for weeks, and the TV pundits are saying the company's peaked — time to cash out and move on. You know they're wrong — the analysts, the short-sellers. They're all sheep you say.
And there it is. You click the link, and it's a dazzling sight. Top- and bottom-line beats. Plus, that's not all: there's [pick your metric] growth that blew even the highest expectations out of the water. After-hours prices are already spiking – up 10 percent, 12 percent, 13 percent.
What goes on in your brain -- that buzz you are feeling, the euphoria that follows -- is very similar to the sensation experienced by addicts from a hit of cocaine, according to researchers at Harvard University.
How the Brain May React Similarly to Investing and Cocaine
From a number of perspectives – the legal one, chiefly – watching a risky financial bet pay off and using cocaine are very different things. But perhaps not to your brain, the research suggests. According to a 2001 paper by Harvard Medical School's Hans Breiter and colleagues, activations seen in four regions of the brain -- the NAc, SLEA, VT, and GOb -- in response to monetary prospects and outcomes overlap those observed in response to cocaine infusions in research subjects addicted to cocaine. (Those abbreviations, if you were curious, mean nucleus accumbens, sublenticular extended amygdala, ventral tegmental and orbitofrontal cortex, respectively.)
In other words, a "fat line" is to a coke addict what a fat win is to a trader (or gambler).
This blurring of the financial and the narcotic sheds light on the behavioral and psychological dimensions of investing, which often go underappreciated. Investors like to think of themselves as rational individuals with the mental acumen, emotional equilibrium and titanium gut necessary to thrive in turbulent markets. But irrational biases can creep in and hurt results.
Bad Decision-Making Can Follow
Among cocaine's most-pronounced side effects is the desire for more cocaine, preferably as much and as quickly as possible. If a savvy (or lucky) bet on a particular stock, currency or lotto number drives you to make another bold wager right away, you're likely to do a bit less homework, think a bit less critically, and perhaps throw a lot of money away. Fiends aren't renowned for their wisdom.
In his book "Your Money and Your Brain," Jason Zweig mentions the brain's similar reactions to cocaine and paper gains, along with a host of other human foibles that can lead to bad decision making. "Financial losses are processed in the same areas of the brain that respond to mortal danger," he writes. A hard-wired tendency to expect anything that happens twice to happen a third time has very little to do with real-world probabilities. Most importantly, these effects are not mere mental ephemera: making and losing money produce "a biological change that has profound physical effects on the brain and body."
Viewed in this light, spectacular trading losses like that of the London Whale – who made JPMorgan Chase & Co. (JPM) $400 million with a single trade in 2011, then lost $6.2 billion the next year – make a bit more sense.
(See also, Unsuccessful Types of Stock Traders.)
The Bottom Line
Luckily, a bit of discipline and frequent reality checks can dampen the effects of psychological biases. The first step, however, is to accept that you are not quite as steely and objective as you'd like to think. You may go by the numbers, but the brain you use to process those numbers is a squishy, unreliable instrument. It evolved to form kinship bonds, hunt big furry beasts and gather nutritious plant matter. Remarkable as it is, it's no Bloomberg terminal.
(For more, read Avoid These Common Investing Psychology Traps.)