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Emotions and How They Affect Investment Behavior

Normal human emotions may overtake the rational part of the brain, and cause investors to make poor investment decisions. Some behaviorists theorize that modern humans are not hard-wired to be good investors. What can investors do to neutralize the effects of emotion and make smarter investment decisions?

Recent times have been difficult for investors. Some have made the situation worse by buying and selling at the wrong times. For most people, the normal emotional response to rising markets is to feel confident and positive. This can lead to the desire to increase risk tolerance and purchase risky assets at potentially high prices. The opposite is true after big market declines. Our emotions may tell us to pull in and avoid risk when, perhaps, the opportunities for higher returns are greatest.

Because of this and other reasons, individual investors are notoriously bad market timers, as evidenced by mutual fund cash flows. For example, The Wall Street Journal recently reported that mutual fund research firm, Morningstar, determined that investors contributed more than $300 billion of new money to equity mutual funds during the six-year period from 2002 to 2007, much of it near market highs. When prices declined, investors redeemed more than $150 billion. According to the Hulbert Financial Digest, the total cost of this poor timing for stock fund investors was more than $42 billion for the 12 months ending May 31, 2009.

As a possible explanation of this behavior, we might consider the interesting work that is being done if the field of neuroscience, where researchers study the brain’s response to stimuli in an attempt to better understand human decision-making. Results are scientifically confirming what behavioral finance economists have suggested for some time: people are not hard-wired to be good investors because their emotions and other “normal” reactions can overtake their ability to reason rationally and make smart decisions under certain circumstances.

Brain scans show that there are two parts of the human brain operating in radically different ways. The prefrontal cortex is the rational, unemotional part of the brain that is used in long-term, logical thinking. The limbic system, on the other hand, is the brain’s short-term, emotional side that often causes trouble for investors. Under certain conditions, our emotional brains can take over and cause us to make poor, irrational decisions.

In a study published in 2005, researchers from Carnegie Mellon, the Stanford, and the University of Iowa, found that people with an impaired ability to experience emotions made better investment decisions in a simple investment game. The game involved a series of rounds in which players could choose whether or not to invest hypothetical money. Each round was structured to have a positive expected return on investment so that a rational player should choose to invest in every round, regardless of what happened in previous ones. Not surprisingly, the normal, unimpaired players were frequently affected by recent outcomes and were reluctant to invest after a series of losses. The players with impaired emotional function invested more regularly and performed better because they were less affected by fear and were more willing to take risk.