No one can be faulted for basking in the glorious returns from the local share market. Up seems to be the only way it’s headed. While it may seem extremely pessimistic to think about what can go wrong at a time like this, now is precisely the moment investors should consider what may lie ahead. Understanding how your brain reacts to financial and investment returns may help you make better decisions in the future.
You have no doubt heard that investment is all about fear and greed, what John Maynard Keynes, a British Economist, famously called the “animal spirits”. In recent years, psychologists and neuroscientists have learned a great deal about the biological basis of these two emotions, but more importantly how they relate to the processing of financial returns.
The neural circuitry in the brain operates two types of goal directed behaviour in pursuing rewards and avoiding losses. The reward system is comprised of neurons that predominantly communicate via the neurotransmitter dopamine, which is sometimes called the pleasure chemical. The reward system coordinates the search, evaluation and pursuit of potential rewards including those from investments.
The “loss avoidance” system is activated when we become aware of threats or dangers in our environment. These brain cells fire when someone throws a stick at you, an attack dog snarls at you or the Milanka Index takes a dive. Anxiety, fear and panic are emotions that arise from this system. The loss system is thought to consist of the anterior insula (pain and disgust), the amygdala (emotional processing), the hippocampus (memory centre) and hypothalamus (hormone secreting centre).
Diagram shows the key parts of the human brain that forms part of the “reward” and “loss avoidance” systems.
Both systems lie beneath awareness but influence thought. They often direct behaviour automatically through subtle emotional influences on judgement, thinking and behaviour.
Increased activation of the reward system can generate optimism, overconfidence and excessive risk taking. Certain parts of the reward system are activated by trust and certainty, satisfaction when rewards are received, learning how to obtain rewards, and learning from success and mistakes. Short term gains energize the dopamine flow of the reward circuitry.
Activation of the brains loss system results in stress, anxiety, disgust, pain and even panic. The behavioural bias of loss aversion is fuelled by fears of disappointment and regret, and arises from the amygdala activation.
Emotions are subjective feelings that serve as easy shortcuts (or heuristics) for the brain. They act like traffic lights for the brain. When considering an opportunity or threat, emotions indicate whether one should go forward with risk taking (excitement), proceed with caution (concern), or stop and withdraw (fear).
Such emotions are anticipatory. They are fundamental to the coordination of thought and action away from danger (loss avoidance) or towards opportunity (reward seeking).
The brain’s comparator assesses one’s actual goal progress against one’s expected progress. In investing, it is where one stands relative to expectations that determines which emotions arise and how one will consider a strategy for closing the gap going forward. The comparator is a feedback system that maintains motivation.
It is due to this process of how your brain and emotions access financial risk that you need to be alert during both euphoric times in the market (as now) and during panics (as we saw during the global financial crisis). Knowing emotions drive most investment decisions is a good place to start making better choices in the current market environment.
First, distrust your emotions. While it feels great to be making money instead of ducking suicide bombs, seeds of all previous market manias (that eventually end in catastrophic busts) are planted when investors are most optimistic. Fundamental company analysis is the only way to make money from stock markets.
Second, have a well articulated reason for buying and owning any company.
It is best to keep a journal so that you can record the underlying reasons for making a purchase. The reason for owning any company has to go beyond a phone conversation with friends or an exuberant broker recommendation. Brokers too are human after all.
Third, investments don't become more attractive after prices go up. What you get out is always a function of what you pay to get in. In a speech in 1963, the great value investor Benjamin Graham warned that "a large advance in the stock market is basically a sign for caution and not a reason for confidence." Finally, hold fast to your independence. When the investing crowd stampedes into the leisure and tourism sectors, as it is now, you should move with extreme caution until the herd moves on.
While it’s fine to enjoy the great returns that the market has delivered of late, just don’t let anyone excite you into a frenzy.
(Our columnist is an Investment Specialist based in Sydney, Australia. You can write to him at email@example.com)