Is there a physiological reason — something in investors’ brains — that causes people to manage their money a certain way?

Patricia Lovett-Reid, senior vice president, TD Waterhouse, and neuroimager, Dr. Ravi Menon, Canada Research Chair in Functional and Molecular Imaging at The University of Western Ontario, have teamed up to help investors understand what is happening in their brains when they make financial decisions — and how they, along with their financial advisors, can use this information to their advantage.

“It is easy to get carried away and make investing decisions based on what we think of as ‘gut reactions’,” says Lovett-Reid. “The truth is that our decision-making process is a complex one — and better understanding how and why we behave the way we do can help investors to make smart choices.”

The human brain was hard-wired thousands of years ago to make split-second decisions based on the information that was immediately available. If our ancestors saw a tiger running towards them, their instincts told them to run away in order to stay alive. No advice was needed since the brain instinctively values short-term gain.

Today, while we may not be running away from tigers, our decision-making is often affected by our emotions and our instincts in the same way. Unfortunately, these instincts are not always very helpful to investors, who are better served by looking at long-term trends and developing sustainable investing strategies. “Different parts of the brain are responsible for different reactions,” says Menon. “By understanding what is happening in our brains during the decision-making process, it becomes easier to take a step back and listen to reason, rather than emotion.”

How four parts of the brain affect investment decisions

1. Battle of the Brain: Prefrontal Cortex
When evaluating a risky decision, brain-imaging studies show a battle between two competing areas: the ventral medial prefrontal cortex, which processes the lure of a big gain, and the dorsal medial prefrontal cortex, which processes the fear of risk.

“This ‘battle of the brain’ is classic greed versus fear. Your emotions can easily get the best of you in these scenarios,” says Menon.

“If you receive a tip and are already thinking ahead to what you’ll buy with your windfall once stock prices rise, you might not process the potential consequences if they don’t,” says Lovett-Reid. “A key way to avoid this is to hire an experienced financial advisor who can help you make unemotional investing decisions. Self-directed investors can also do this by setting strict rules for themselves. For example, if you book profit on a 20% upside in a stock, have the discipline to book a loss if you lose 10%.”

2. Fight or Flight: The Amygdala

“The amygdala is a part of the brain involved in feelings of fear — the ‘fight or flight’ response. This can be an irresistible force, which has been honed over thousands of years,” says Menon.

“Fear can be a major obstacle to successful investing, causing you to behave irrationally and do things you might regret,” says Lovett-Reid. “It is important to build a portfolio suited to your risk tolerance and be invested for the long-term. If you know you have time to let your investments grow, fear-inducing dips can come and go without making you nervous.”

3. I’m Feeling Good: The Nuclei Accumbens

The brain’s ‘reward centre’ is situated just behind each eye in the nuclei accumbens. This area, responsible for feelings of happiness, causes as much trouble for some people as fear does for others.

“If you make investment decisions that help your portfolio rise in value, your happiness level will likely rise with it,” says Menon. “The nuclei accumbens is one area that lights up when this happens. Acting exclusively under its influence could lead you to make mistakes.”

“The trick with investing is to make that feeling of happiness last-without taking on too much risk,” says Lovett-Reid. “For this reason, it is important to employ strategies that don’t tempt you to chase risky short-term gains. Happiness can come from being disciplined, focusing on your long-term goals and avoiding the temptation to try and time the market.”

4. Remember What Happened Last Time?: The Hippocampus

“Though many other structures are used in the development and recall of memories, the hippocampus is often regarded as being critical in the formation of long-term memories,” says Menon. “When we create a new, long-lasting memory, it passes through the hippocampus numerous times until it has become fully formed.”

“Investors need to ensure that potentially negative memories from an experience like the recession do not cause investing paralysis,” says Lovett-Reid. “It is important to keep track of what has worked and what did not, but it is also essential to look ahead, not back, with the understanding that while it is not possible to avoid future economic downturns, it is possible to be prepared.”

Good advice is important

“The decisions we make that affect our money can be fraught with emotion,” says Lovett-Reid. “Instead of trying to eliminate that emotion entirely, which is very difficult, it is important to recognize that there is a lot going on in our brains every time we make an investing decision and plan accordingly. This means adopting good habits and sticking with them, ensuring you have a well-defined financial plan and finding an advisor you trust.”

IE