The Financial Errors We Don't Realize We're Making

Conflicting emotions influence investment decisions, and investors are faced with the challenging task of overcoming irrationality when making investment decisions

In the science fiction movie Equilibrium (2002), the population is required to inject a mind altering drug daily to suppress emotion. The idea is to eradicate wars by ablating feelings that might cause them.

Since I haven’t seen the film, I don’t know if it worked, but my guess is that it did not or there wouldn’t be a movie.

Secondly, and even more importantly, emotions are very hard to suppress. They work in mysterious ways that we don’t even recognize most of the time.

That is because the part of the brain involved with emotion is below our radar. We can thank our midbrain—the primary area where our emotional processing occurs, also referred to as the limbic system. The midbrain is between the brainstem, which supports vital functions such as breathing, and the cerebral cortex, which is assigned thinking and executive function.

Within the midbrain, we have two motivational systems that never reach consciousness. One is to gain reward and the other is to avoid pain. These two are often in conflict. Understanding their dueling natures can benefit investment decisions.

The reward/avoidance pathways and financial decision-making

Richard L. Peterson’s chapter, “Neurofinance,” in Investor Behavior (Wiley, 2014) provides up-to-date insights as to how the reward/avoidance pathways influence financial decision-making. For instance, framing how a question is asked can influence the answer. The term, framing, refers to the phrasing, whether it is positive or negative.

Example:

If experimental subjects receive $95 and are told they can keep $38 or gamble, the volunteers were weighted toward holding on to the safe bet ($38) and choosing not to gamble. On the other hand, if the participants were told that they could lose $57 (of the $95 thereby keeping $38) or gamble, the participants were stacked toward gambling.

In both cases, the participants kept $38; though whether or not they chose to gamble depended on how the question was framed. Focusing on a loss (negative) of $57 tended to lead to gambling whereas concentrating on a gain (positive) of $38 resulted in betting less often.

When studied with functional magnetic resonance imaging (FMRI), it was the amygdala (fear) that was stimulated in the subjects during loss aversion. If the framing effect was resisted—as it was in some subjects—the orbital frontal cortex that integrates emotion and reason was activated, as well as the anterior cingulate cortex, which is known for sorting out internal conflicts.

What this demonstrates is that conflicting emotions influence investment decisions, sometimes paradoxically.

We mortal humans are faced with the challenging task of using our orbital frontal and anterior cingulate cortices to overcome irrationality when we make investment decisions.

The abbreviated anatomy and chemistry of the reward pathway

The reward pathway includes the pleasure center known as the nucleus accumbens, and associated extensions with these technical names: the medial posterior frontal cortex and the anterior cingulate cortex. The former helps process risk and fear and also plays a role in the inhibition of emotional responses during the process of decision-making, while the latter is involved with empathy and impulse control, among other functions.

The chemical associated with the reward pathway is dopamine, loosely referred to as the pleasure chemical. When stimulated, the dopamine system produces a feeling of well-being. On the other hand, if it is desensitized or unable to respond, apathy sets in. Sensation-seeking behaviors may be used in this circumstance in an attempt to compensate: for example, the use of illicit drugs or compulsive gambling.

The anatomy and chemistry of the avoidance pathway

On the other end of the spectrum is the avoidance system. It runs through several areas of the limbic structure—most importantly, the amygdala and the anterior insula. The amygdala is traditionally associated with fear and the insula with disgust.

It is serotonin and norepinephrine (among other neurotransmitters) that are associated with avoidance. When activated, this loss system results in stress, anxiety, and pain. It is not only the brain that is affected, but also the entire body is bombarded with the hormone and neurotransmitter release. This can cause an increase in heart rate, perspiration, and uncomfortable feelings. If the stimulation is chronic, neuroticism can result, which is associated with risk-averse choices during decision-making.