May 01, 2014 | My Money MD | Shirley M. Mueller, MD
George Soros, one of the greatest stock market traders of all time, lets his body guide him in his financial decisions. When his back hurts, he knows he’s in trouble with a market position and lightens his position. If his mouth waters, he feels good about his bet and hangs on.
It’s as though his nervous system conveys information to him that helps him trade. He listens, takes it into consideration and makes his judgment. The financier’s sensitivity to his internal biological system paid off handsomely. His success begs the question—should we be listening, too?
Though some might scoff at this notion, the new science of Neuroeconomics suggests Soros is on to something. This emerging field studies the physiology behind financial decisions, focusing on brain-body reactions and interactions that occur during monetary choices. Its findings suggest that humans have underlying hardwiring that tends to both enhance and sabotage investment efforts. Insight into this area is vitally important for economic success, because identifying our innate strengths, as well as weaknesses, means we can capitalize on the former and strengthen the latter. Armed with this knowledge, investors can be more like George Soros.
This is a recent concept. As little as a few years ago, most believed the market was efficient, all known information was taken into account, and people acted rationally on their own behalf. Emotion was not part of the known investing equation. Then, Andrew Lo, of the Massachusetts Institute of Technology, and Craig MacKinlay, of Wharton School of Business, came along. They re-examined this hypothesis and found that stocks have non-random movements suggesting that financial markets are not as straightforward as previously thought. Inefficiencies occurred. If they are understood, they have the potential to be exploited for profit.
Behavioral economics stepped in to contribute. Its practitioners searched to explain the psychological underpinnings of nonrandom markets by combining studies in human behavior and economics. Daniel Kahnemann and Vernon L. Smith won the Noble prize in Economics for work this area in 2002.
Finally, in the last 12 years, researchers are explaining the neurological processes behind behavioral economics. Neuroeconomics was born, started by a group of scientists focused on biologic research that explains how people make economic decisions. Where behavioral economics has a psychological basis, Neuroeconomics is biologically grounded. Information from this cutting edge field provides insights as to why we do what we do in the financial markets.
Some of our inherent biological tendencies lead to actions that enhance our odds of making money. Others channel us in the reverse direction. Our job is to be able to recognize which characteristics guide us toward wealth and which direct us in the other direction. Then, we can accentuate our natural attributes that help us and curve those that are getting in our way.
This new information plays right into theories that academicians have tossed around for years—that we have 2 ways of thinking. One is intuitive or instinctive. The other is analytic.
Instinctive reasoning is off the cuff, an almost unconscious reaction. It is directed by internal feelings coalesced through previous experiences, a sum of emotional knowledge. As such, it is fast to come to mind and extremely handy to access though inadequate information may play into its assessments, and certainly there can be lack of logic.
Analytic thinking, on the other hand, is slow and deliberate, a conscious response. It works with external data such as a page of numbers or a table in Forbes. Processing it can be laborious and even mind numbing. If errors are made, contributing issues include our own lack of capacity or extraneous factors like time pressures.
In the majority of us, the most important factor that influences our financial decisions is intuition, not analytic thinking.