Neuroeconomics

Posted by on October 3, 2009 in Financial Planning, Readings | 0 comments

I recently began reading Your Money & Your Brain: How the New Science of Neuroeconomics Can Help Make You Rich by Jason Zweig. For warm-ups, he gives examples of how knowing better doesn’t mean we’ll do better and runs down some basic lessons we’ve learned as the field of neuroeconomics has progressed.

My favorite “case study” was that of Harry M. Markowitz, the “father” of Modern Portfolio Theory and winner of a Nobel Prize in economics (1990), who was unable to apply the mathematical breakthrough he’d helped discover to his own investment portfolio. Instead, in the 1950’s, he chose to invest 50% of his retirement savings in stocks and the other 50% in bonds. Markowitz said, “I should have computed the historical co-variances of the asset classes and drawn an efficient frontier. Instead, I visualized my grief if the stock market went way up and I wasn’t in it – or if it went way down and I was completely in it. My intention was to minimize my future regret.”

Markowitz’s sentiment was echoed by another Nobel Prize winner, Daniel Kahneman (the first psychologist to win a Nobel Prize in economics), who said, “Financial decision-making is not necessarily about money. It’s also about intangible motives like avoiding regret or achieving pride.”

So what does the research show? So far, here is some of what we’ve learned through the study of neuroeconomics:

  • Monetary gains and losses create a biological change, which can profoundly affect the body and the brain.
  • The neural activity of someone making money on their investments is indistinguishable from that of someone high on cocaine or morphine.
  • After a stimulus, such as an uptick in the price of a stock, is repeated twice, the brain “automatically, unconsciously, and uncontrollably” expects a third recurrence.
  • Once someone presumes that investment returns are predictable, their brain will respond in alarm when that presumed pattern is broken.
  • Financial losses and mortal danger are processed in the same areas of the brain.
  • “Anticipating a gain, and actually receiving it, are expressed in entirely different ways in the brain, helping to explain why ‘money does not buy happiness’.”
  • “Expecting both good and bad events is often more intense than experiencing them.”

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