Human Behavior & Investment

Human Brain is divided in to three major sections

Outer Layer
Middle Layer
Inner Layer

Outer layer of the brain is known as the Rational Center, which handles complicated cognitive processes, such as objective thinking & rational decision making. It is also known as cerebral cortex. The cortex is the brain’s logistical centre. It is the director of executive function & motor control. The part of the cortex called the prefrontal cortex is most interest to this discussion. The prefrontal cortex is involved in abstract thinking, planning, calculation, learning, & strategic decision making.

Middle layer is considered to be emotional centre. It is also known as limbic system. The brain’s limbic system is the emotional driver of the brain. Within the limbic system is the amygdala, which processes the emotions, translates outside situation in to specific emotions such as fear or excitement.

Inner layer is knows as Habit Center. Habit centre processes everything we do automatically without thinking. It includes not only habits but also basic body functions such as breathing, circulation, movement & sensations. The most significant anatomical part of the habit centre related to financial decision making involves the basal ganglia, which automatically seek out anything we recognize as rewarding, thus leading to the formation of habits.

These three parts of the brain Rational Centre, Emotional Centre & Habit Centre work to getter. They are connected to each other by neural circuits, i.e. pathways that use special chemicals to send information back & forth among different part of the brain.

Let us consider an example.

If you have gone long in the stock Market with huge investments and suddenly you get a message that there is a big scam. Within 10 to 12 milliseconds what you heard, activities part of your brain, that processes emotions & you feel frightened & anxious, your emotional brain immediately sends a chemical message to your inner brain, your heart will start beating faster & your breathing to become shallower, you try to figure out whether stock markets has slide and suddenly some other bad news flash on television related to stock markets.

In the case the layoff rumor, for instance, our anxiety & fear blocked our ability to make a rational decision to check out the accuracy of the rumor. The danger system is the circuitry in the brain that gets activated when we feel threats to our survival. You decide that the rumor is probably true so your anxiety level rises & your heart rate continues to beat rapidly all of this has happened in a matter of seconds you start to panic. Market has slide and you have sold all your stocks, and further you have gone short in the stock market. Now you are sure that the markets will slide further. But suddenly stock market rises without any reason. And now when you had gone short you have to square up your position. You incur a huge loss.

Most financial phenomena are not governed by predictable patterns.

Stock market goes up – we think it will keep going up.
Real Estate market is hot – we assume it will continue.
We have gotten a rise in our income every year – we expect to see increase next year.

There is no reason to believe that something will keep happening just because it has been happening. In fact if the past is the predictor of the future, then what it really tells us is that what goes up must come down & vice versa (Neutrons Law).

As hersch shefrin says “Past performance is a great predictor of future expectations, not future performance”

Most investors avoid financial risk after a recent loss, to their financial detriment. Risk avoidance is pretty smart after most type of losses -that’s how we learn from mistakes & try to avoid unhealthy risk.

Emotions are subjective feelings that serve as easy shortcuts for the brain. On the one hand, the emotion of excitement indicated that one had identified an opportunity. Excitement propels increased risk seeking & exploratory behavior. On the other hand, the emotion of fear notifies one of the potential dangers. Fear gives rise to behaviors of risk aversion and withdrawal.

Emotions are like a traffic light 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 withdrawal (fear). Such emotions are anticipatory. They help people broadly prepare for threats or opportunities and they are fundamental to the coordination of thought and action away from danger (loss avoidance) or towards opportunity (reward seeking).

As a further example, among many investors fear leads to knee jerk expectations of an impending recession or price decline, and it often drives premature selling of risky holdings. Yet if you ask a fearful investor why they are selling, they usually won’t say “because I’m afraid”, rather, they might cite negative economic events. Emotional investors are unaware that it is not facts that are driving their outlook, but perceptual distortions caused by feelings.