Mind over matter: Processing financial decisions

  • Investment management
  • 5 minute read

In the past we have written about behavioural finance and the impact of emotions and individual differences on investment and financial planning decisions.

While cognitive psychology and economics, working together, have furthered our understanding of observable behaviour, an emerging multi-disciplinary field is aiming to shed some light on the underlying neural mechanisms that influence decision-making. This field is known as neurofinance.

What is neurofinance?

Neurofinance uses neuroscience techniques to monitor our subconscious responses to risk and reward in an attempt to deduce how and why people make financial decisions. There is a vast body of research on decision-making within psychology and neuroscience. Neurofinance seeks to apply this research to the world of finance, deepening our understanding of investment behaviour.

Advances in technology have helped neuroscientists to map the chemical and electrical processes occurring in our brains when we make decisions in a non-invasive way. The most commonly used techniques measure the electrical or magnetic fields generated by the neurons that are involved in processing information.

These are electroencephalogram (EEG) or magnetoencephalogram (MEG). Functional magnetic resonance imaging (better known as fMRI) can also be employed to provide information about the movement of blood to the areas of the brain that are active during specific tasks. When combined with behavioural observations and finance theories, this additional neural data helps us to understand how our brains process financial decisions.

What has the research shown?

Behavioural analysis has shown that risk preferences can vary significantly, with gender being an influential factor. The 2009 study, Gender Differences in Preferences, by Rachel Croson and Uri Gneezy, suggests that men are more tolerant of risk than women, but it is unclear as to why. Separately, a 2014 study conducted by João Vieito, Rachel Pownall, Armando Rocha and Fabio Rocha has demonstrated, using EEG technology, that men and women use different parts of the brain to make the same financial investment decisions. Studies such as this offer some evidence as to why financial decision-making processes, and the outcomes of them, differ significantly between men and women.

Economic modelling relies on the assumption that people behave rationally, but brain scanning has begun to confirm the huge effect that our emotions have on our decision-making processes. Every decision we make has an emotional element to it, and investing is no different.

We know from behavioural studies that we feel losses more keenly than gains, which results in loss aversion. MRI scans have shown that this is reflected in brain activity – there is greater activity in areas associated with negative emotions than equivalent areas associated with positive emotions.

The financial crash of 2008 exposed investors to be behaving in ways that would not have been predicted by theoretical models. Behavioural finance draws on insights from the behavioural sciences that go above, and beyond traditional finance and the assumption that real people behave rationally.

For example, traditional finance assumes that expected benefits are a projection of complex future earnings. Yet brain scan studies show that people actually assess benefit using the emotional centres of the brain. Therefore, while economics defines benefit as an analytical variable, neuroscience shows that, in practice, it is a subjective evaluation.

The same applies to the assessment of risk. While economics considers risk to be a function of the probability of certain events occurring, studies have shown that risk perception has both quantitative and qualitative components. Typically, investors assess risk despite having limited information about probability, and use emotion-processing circuits. As emotion or sentiment can be heavily influenced by external factors, such as the news and information we consume, it is therefore theoretically possible that changing these inputs could change the outputs – in this case, our financial decisions.

So what?

Why is it helpful for us to understand more about the neural bases of our decision-making? Research to date leads us to a deeper understanding of the type of information that our brains can process efficiently, and the type of information that they cannot process efficiently, as well as the conditions we need to make advantageous decisions. If we can better predict investor behaviour, the hope is that we can also correct some of our natural biases and develop nudges to help real people make smarter financial decisions. The future should bring some exciting insights into how we can improve investment decisions at both an individual, and an organisational, level.

 

Your Close Brothers adviser can help you to neutralise your emotions and stay on track to reach your financial goals in even the most challenging market environments.

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