Caution: Your Brain Really Loves Anticipating Financial Gain

Did you know that you are more aroused when you anticipate a gain than when you actually realize the gain? The anticipation puts your reflexive brain into high alert.

Studies using MRI scans show that the part of the human brain that anticipates financial gain is the same area of the brain that experiences sexual pleasure and anticipates food. In fact, it is the expectation or arousal that is the main component of euphoria.

Your brain treats financial gain in the same manner it treats a broader group of rewards such as food, drink, shelter, safety, sex, drugs, and beautiful faces.

Our brains were designed to help us survive through the thrill of anticipation. It is the anticipation circuitry in our brains acting as a beacon of incentive that allow us to pursue longer term rewards. If we did not get pleasure from anticipation we would not be motivated to hold out long enough to earn them.

Anticipation also responds more to the size effect versus the probability of an event. In other words the, how big the reward has a stronger effect than a high probability reward. To quote Zweig: " when possibility is in the room, probability goes out the window"

Further more, we derive even more pleasure when we have a chance that we may lose money. Think about it, evolution has designed us to pay more attention to rewards when they are surrounded by risks.

So what can you do as an investor to manage your investing arousal (greed). Jason Zweig, in his book "your Money & Your Brain" says that the first thing to know is that your anticipation circuitry will get carried away. He gives some checks and balance ideas to help:

1. Be on the alert for the promise of a big score. Ask yourself : "what does this person know that others don't" or " Why is this person letting me in on this great investment secret" and never, never respond to an unsolicited offer.

2. Lock up your mad money and throw away the key. Put 90% of your stock money in low cost diversified index funds that own everything in the market and then put 10% into speculative investments. And, don't move money from your 90% account into your speculative account.

3. Think twice - making an investment decision while you are aroused by the prospect of a big gain is a bad idea. Go distract yourself for a period of time and let your reflexive brain calm down .

Our Brains and Investing History

I have currently being reading a wonderful book on the history of financial speculation:  Devil Take The Hindmost, A History of Financial Speculation, by Edward Chncellor.

While reading this book, I have been re-posting some chapter summaries from Jason Zweig's, Your Money & Your Brain, and I cant help but see the connection between how our brains drive us and the booms and busts we see in the investment cycle.

What we know is that making money creates a euphoria in our brain that is similar to a cocaine high. But when we start to lose, our lizard (reactive) brain takes over and we panic and flee. Neither state is rational.

What we have observed in the 300 years, or so, of market history is that financial markets tend to swing wildly. This is not new to the last few years. There is a rich history of boom and bust cycles. Investors drive up the price of everything; from tulips in Holland in the 1600's to on-line pet stores in the 1990's, all in an irrational frenzy of greed, then see it destroyed when some event trips their collective lizard brain into a protective panic state. As I read I will occasionally leave some quotes from the book that reflect how investment history repeats itself. It was already reapeating itself in the early 1800's. This from Lord Overtone in 1825:

"First we find it in a state of quiet, -next improvement,-growing confidence,-pressure,-prosperity,-excitement,-overtrading,-convulsions,-pressure,-stagnation,-distress,ending again in quiet."

Maybe Wall St, or government policies are not to blame for extreme fluctuations in investments, maybe our collective human brains are more to blame.

BEWARE: Your Lizard Brain Can Dominate Your Investing Decisions.

From Jason Zweig's Your Money and Your Brain:

The reflexive brain (or lizard brain) is that part of your brain that reacts to external stimuli, sometimes within a tenth of a second. It has developed to protect us from risk in our environment. It operates below the level of consciousness.

This is important to understand because your reflexive system is so fixated on change it is hard to focus on what remains constant. For example, we react to a 100 point drop in the Dow, but we don't keep it in context that it is only a 1% drop. Academic studies have shown that investors who focus on price levels outperform those who focus on price changes.

The other part of your brain: the reflective brain organizes information, categorizes it and tries to develop patterns. But, you cant depend on your reflective abilities, they are limited by your memory and the complexity of the problem.  Doctors and engineers as a group are poor investors because they try to find patterns and they miss the unforeseen event that renders their system useless.

The lizard brain dominance over the reflective brain can be observed in the average investors purchase of mutual funds. Most investors focus on the flashy factors when choosing a mutual fund: mutual fund manager, recent performance, reputation. They ignore fund expenses, which rigorous study has shown to be the most critical factor in predicting future performance.

Based on studies like the  annual Dalbar study of investor behavior, it is evident that our lizard brain dominates in most decisions for the average investor. 

It helps to have a trusted advisor, paid or unpaid with some understanding of human and market behaviors, to help you manage your natural reactions and stay true to your investment course.

An understanding of your brain functioning could improve your investment performance.

From Your Money and Your Brain, by Jason Zweig, writer for the Wall Street Journal.

In the book, Jason introduces the reader to the field of Neuroeconomics -the combination of imaging technology and psychological studies that have lead scientists to better understand humans reactions to risk. It explains why our investing brains often drive us to do things that do not make logical sense but make perfect emotional sense. Our brains were developed to survive - to react to risk. Our logical brain is no match for our reactive, risk protecting brain.

Scientists have found:

* Monetary gain or loss has a profound physical effect on the brain and body.

* The neural activity of someone making money is indistinguishable from that of someone high on cocaine.

* Financial losses are processed in the same areas of the brain that responds to mortal danger.

* Once people believe that an investment return is "predictable" their brains respond with alarm if the pattern is broken.

The key for investors and investment professionals is to understand the above psychological effects and better manage them. Many recent supporting studies indicate that the average investor severely under performs market benchmarks because of these effects.

Think you can invest without help? Think again.

The 2010 DALBAR report: the Quantitative Analysis of Investor Behavior (QAIB) has recently been issued.

DALBAR is a third party analyzer of the financial services industry. They have been analyzing investor behavior for almost 2 decades.

This years report indicates that the average equity investor outperformed the S&P 500 in 2009, and the average bond investor did better than the Barclays Aggregate Bond Index in 2009.

That is the good news. The bad news is that over the 20 year period ending 12/31/2009 the average equity investor's return of 3.17% was well below the S&P 500 20 yr return of 8.20%. As well, the average bond investor returned 1.02% over 20 yrs compared to the index return of 7.01%

The numbers are dramatic and many, including DALBAR, conclude that investors do not buy and hold. They become irrational and buy and sell at the wrong times.

The same conclusion was reached in a study, highlighted in a recent NY Times story, by Philip Maymim , a professor of finance and risk engineering at Polytechnic Institute of New York University. Professor Maymim found that the value of an investment advisor is not in the stocks or mutual funds they recommend but in their ability to prevent an investor from impulsively trading at the wrong time.

I would also add that a good advisor starts by placing the investor in the appropriate portfolio for their risk tolerance and time horizon, then hold their hand and keep them on course.

The NY times story: http://www.nytimes.com/2011/03/12/your-money/stocks-and-bonds/12wealth.html?_r=1&ref=business

It most cases it will pay for investors to find an advisor they can trust. I recommend an independent fee-only advisor who has no conflicts of interest from commissions and who has a good understanding of market history and investor behavior.

AWM analysis of weighting of US/International Stocks

I recently had my University of Buffalo graduate student of financial engineering, Shwetha Narayan Iyengar complete an analysis on the diversification effect of adding international stock to a stock portfolio.

The study summarized below is not a recommendation , rather it shows how adding international stocks can reduce overall risk and improve return.

There is debate on how much non-us stock should be in stock portfolio. The results do seem to support those that argue that investors should hold stocks in proportion to their weighting in the mix of all stocks issued by all nations. The US currently makes up about 45% of the global capital market.

Keep in mind that this analysis does not include emerging markets or factor in value or small cap effects. It does support a diversification into international stocks when building your stock portfolio.

The summary:

Analysis of total US market vis-à-vis the other developed markets in a portfolio.

The CRSP 1-10 Index represents the total US cap weighted equity market. It measures the performance of all stocks aggregated across NYSE, AMEX and NASDAQ markets, spilt in deciles from large cap to small cap. MSCI EAFE index measures the equity market performance of developed markets outside of the U.S. & Canada and includes Europe, Australia, New Zealand (Australasia) and Middle East

Annualized returns and Standard deviation (measure of risk/volatility) for CRSP and EAFE for a period from 1970- 2010 are as provided below,

Annualized	Returns	STD deviation
CRSP1-10	9.88%	16.13%
EAFE	9.94%	17.25%

Portfolio with 45/55 ratio of CRSP 1-10/EAFE gives the highest return for risk ratio (Sharpe ratio) and to further validate, a Monte -Carlo simulation value averaged over 3 independent simulations provides a higher value at 90 percentile or 10% probability of going above the value. (Monte Carlo is a statistical tool that will estimate probable outcomes for a particular set of risk and return inputs)

Weights
CRSP1-10	55%	60%		65%	70%	75%		80%		85%
EAFE	45%	40%		35%	30%	25%		20%		15%
Return Portfolio	10.196%	10.185%		10.168%	10.145%	10.116%		10.081%		10.040%
Std deviation Portfolio	14.910%	14.899%		14.926%	14.989%	15.089%		15.226%		15.400%
Sharpe ratio	0.311938	0.311430		0.309728	0.306892	0.302936		0.297911		0.291883
Wealth at retirement (90-percentile) from Monte Carlo simulation
Scenario 1	$4,893,889		$4,590,990	$4,450,640	$4,763,008	$4,428,423	$4,755,993		$4,338,645
Scenario 2	$4,593,936		$4,237,107	$4,514,705	$4,570,777	$ 4,709,112	$4,748,913		$ 4,483,666
Scenario 3	$4,610,162		$4,517,348	$ 4,627,469	$4,369,035	$ 4,385,526	$ 4308,407		$ 4,631,853
Average, Wealth at retirement (90-percentile) MonteCarlo simulation	$4,699,329		$4,448,482	$4,530,938	$ 4,567,607	$ 4,507,687	$4,604,438		$ 4,484,721

The most optimum scenario is 55/45 portfolio. A higher weighting of CRSP 1-10 reduces the Sharpe ratio, the return and the final value of the portfolio. If the analysis is expanded using higher weights for the MSCI EAFE and lower weight for CRSP 1-10 , the result does not vary much and the most optimum portfolio still remains as 55/45 .

Start saving and planning before its too late: WSJ 2/19/2011

In my financial planning practice, I am constantly working with clients who are not prepared for retirement. This WSJ article paints a good picture of the average American approaching retirement:

http://online.wsj.com/article/SB10001424052748703959604576152792748707356.html?mod=ITP_pageone_0