Behavioural Finance: Part 1 – how knowing your brain can give you the edge
Behavioural economics, behavioural finance and neuro-economics are now familiar terms in the world of finance, but how can you apply these principles to trading?
In this series of three posts, behavioural psychologist Paul Davies opens the bonnet on our personal trading engine—our brain—to uncover the secrets of how we act as individuals, how groups trade and how we can implement strategies for better trading.
In this post, we’ll take a look under the hood of our decision-making engine to see what drives our actions. A quick tour of the highways and byways of our brain will provide a foundation for understanding how our little grey cells can push us towards poor investment decisions.
‘how our little grey cells can push us towards poor investment decisions’
This foundation will pave the way to the next two posts in this series, where we’ll go into detail about arming ourselves with a personal decision checklist and how to use this knowledge to appreciate how group decisions influence the market.
Have you recently been smiled at when driving? Not from a flirty passer-by or an appreciative pensioner, but from one of the new speed indicators appearing all over the UK which flash a smiley face when you’re travelling under the speed limit, and an unhappy face if you’ve gone too fast.
Whether or not you’ve come across one of the Smiley SID (Speed Indication Detection) cameras, do you think it would make you slow down?
When researched, people remarked that it wouldn’t affect them; they wouldn’t be influenced by something as puerile as a dot-matrix face.
Instead people predict signs showing their speed would be more effective – after all, if we have the right information, we can make a rational decision.
Interestingly, these signs are a great example of how we’re awful at predicting our behaviour and what influences it. When it comes to speed indicators, a Brisbane trial observed a 40% sustained decrease in speeding when they replaced traditional cameras with Smiley SIDs.
The reason we think Smiley SIDs will be ineffective is we assess such interventions with a part of our brain quite different from the area that decides to ease our foot off the accelerator.
This dichotomy between what we think we’ll do in certain situations and what we actually do is incredibly powerful, especially when trading.
Understanding how we as individuals react to events and make decisions in the context of groups can give us the insight to cross-check our reasoning, avoid the herd mentality and find the opportunity to take an alternative path.
The Rise of Behavioural Economics
The last ten years have seen a surge in interest about how our brains influence our financial behaviour.
In the aftermath of the 2008 financial crisis, economists opened their doors to researchers from psychology, anthropology and neuroscience in the hope of shedding light on how neoclassical economics could have got it so wrong.
Behavioural economics, behavioural finance and neuro-economics are now terms that regularly pepper the pink pages of the Financial Times, and books such as Nudge by Cass Sunstein & Richard Thaler and Predictably Irrational by Dan Ariely have become best sellers.
Daniel Kahneman was the first non-economist to win the Nobel prize for economics in 2002, and only last year Richard Thaler joined him for his work applying psychological assumptions into analyses of economic decision-making.
In fact, the topic has become so de rigueur I would even predict many of you have a pristine copy of Daniel Kahneman’s Thinking Fast and Slow proudly sitting on your bookshelf alongside an untouched copy of Stephen Hawkins’ A Brief History of Time.
‘overturns the idea that we make rational decisions based on perfect information’
The reason behavioural economics has become so mainstream is due to its attempt to drag that unpredictable element back into economic models – the human mind.
It overturns the idea that we make rational decisions based on perfect information and accepts that emotion is not a dirty word when talking about economics.
As Rory Sutherland, Vice Chair of Ogilvy Group UK, boldly put it, “Economics is and should be a social science, not a masturbatory exercise in numerical modelling which achieves a spurious mathematical neatness at the expense of stripping away from human behaviour almost everything that makes us human.”
Who’s Really in the Driving Seat?
Let’s get back in the car for a moment, this time ignoring any speed detection cameras. Imagine driving along, thinking about an argument you had at work.
Unexpectedly, a child runs out from behind a parked car right into your path. You slam on the brakes, and screech to a halt only inches away from the now crying child.
It’s a nightmare scenario none of us wants to encounter, but what happens in our brain as the events unfold?
We nearly always talk about the brain as it were a single lump of matter, but in reality, our brain is more complex. For our purpose I’ll use a simple abstraction, and divide the brain into three distinct parts; the old brain, the mid-brain and the new brain.
The old brain developed first on the evolutionary timeline and is present in all animals, and it’s concerned with our survival. It oversees our breathing, heart rate, digestion and is continuously surveying the environment for potential danger.
The mid-brain is where our emotions are processed; it has deep connections with the brain’s dopamine system leading to love, anger and impulse buying.
Finally, the new brain is the part we’re probably most familiar with, the mass of swirling pink valleys making up the two hemispheres of our cortex. From an evolutionary standpoint, this is the most recent development and governs rational thinking, planning, deliberation as well as language, memory and speech.
As we drive along, especially on familiar routes, our old brain is moving our muscles to control the car and is scanning the road for danger. The new brain is passing visual information to the old brain while our mid-brain is reliving the emotion caused by the argument at work.
‘our new brain doesn’t make the decision to stop, if we waited for that to happen the situation would not have ended as well’
As our old brain spots the child, it triggers some of our 100 trillion synapses to flood our body with adrenaline to be ready for action and reacts to slam the brakes as you come to an abrupt and ultimately safe stop.
Your mid-brain is now awash with dopamine, making you feel scared but relieved and your new brain starts thinking if you were speeding or if you could have done anything to avoid this happening.
Notice in this example how our new brain doesn’t make the decision to stop, if we waited for that to happen the situation would not have ended as well.
Instead, the combination of our old brain and mid brain structures did their job lightning fast and without our conscious awareness.
The new brain only really came to life once the situation was over, performing analyses and assessments after the event. Daniel Kahneman described this process as thinking fast and thinking slow, where fast thinking happens in the emotional limbic structures of our brains and our conscious cortex is relatively slow in its high-level deliberative thoughts.
Trading Fast and Thinking Slow
Technological advances in brain imaging techniques over the past 15 years allows researchers to watch the brain as it makes financial decisions, and pinpoint the areas involved.
And it turns out that, much like our driving scenario above, our rational prefrontal cortex doesn’t play as significant a role as we might think.
When making complex choices, evidence shows that the emotionally charged areas of our brain—mostly held within the limbic system—identify and create strategies before our rational cortex is even aware a strategy is being deployed (Damasio, Tranel and Damasion, 1997; Sanfey et al., 2006).
Many psychologists and behavioural economists describe these emotional decisions as irrational, as they don’t act in our best interests especially in complex situations such as investing.
My personal view is this is being harsh; our brains evolved slowly over thousands of years to be able to make rapid and automatic decisions to survive in an environment where slow and conscious deliberations would have fatal consequences.
Today, when faced with abstract financial concepts such as runs on the market and price crashes, the emotional mid-brain retains control despite the change of environment.
‘it explains common ‘investment mistakes’ such as being too conservative with risk, buying high and selling low’
With the fear of loss appearing as the single most influential emotion, it explains common ‘investment mistakes’ such as being too conservative with risk, buying high and selling low, excessive trading or not investing at all (Panizza, 2016).
So if our brain unconsciously acts against us when faced with complex market fluctuations, what hope have we got to avoid irrational exuberance, the lure of greed and fear and the desire to follow the herd?
The good news is that having read this far, you can replace the traditional economic model of being a ‘single, rational, utility maximising actor’ with the ‘duel-self theory’.
Having the intelligence and humility of knowing you’re fighting a battle with your inner passions (as Adam Smith described them) when making trading decisions, gives you the advantage of adopting protection tactics to both keep your head when all about you are losing theirs, and to implement a rigorous long-term investing strategy to take advantage of market volatility.
Paul Davies is a behavioural psychologist consulting in the fields of health and finance. He has worked alongside companies such as Santander Asset Management, Old Mutual Wealth, James Hay Partnership, Equiniti and Kilik and Co.
EQi is a DIY investing platform designed for individuals. It gives you access to global markets, control over your investments and offers customers award-winning support.