Affect and Financial Decision-Making: How Neuroscience Can
Inform Market Participants
Q1: Au: Please add Reference (from page 10
The Journal of Behavioral Finance 2007, Vol. 8, No. 2, 1–9 The Institute of Behavioral Finance Affect and Financial Decision-Making: How Neuroscience Can
Inform Market Participants
Richard L. Peterson, M.D.
We review recent neuroscience literature on the influences of moods, attitudes, andemotions (affects) on financial decision-making. Evidence indicates the existence of separate brain systems, linked to affect processing, that are responsible for risk-takingand risk-avoiding behaviors in financial settings. Excessive activation or suppressionof either system can lead to errors in investment choices and trading behaviors. Wesuggest ways for market participants to become aware of the potential impact ofaffect on their behavior in order to avoid suboptimal financial decisions. This paper has two overall aims: to educate financial practitioners about the origins of emotionsthat can adversely impact their performance, and to teach investors how to makebetter financial decisions. keywords: Affect, Finance, Markets, Neuroscience, Decision
represent small expected losses. To explain further, weoffer an explanation derived from understanding the Recent financial research has shown that individual brain's affective and motivational circuits.
investors systematically deviate from optimal trading Affect is defined as the subjective and immediate behavior (Daniel, Hirshleifer, and Teoh [2002], experience of emotion attached to ideas or objects Hirshleifer [2001], Odean and Barber [1998]). Some (Sadock [2000]). Affect often has outward manifesta- authors hypothesize that affect (emotions, moods, tions, such as altering normal facial expressions, vocal feelings, and attitudes) plays a prominent role in tones, and physical posture. Positive affect indicates financial decision making (see Lo and Repin [2002] optimism, and the evaluation of a decision based on and Lucey and Dowling [2005] for an excellent potential gain. Positive affect motivates us to continue review). However, the mechanisms by which affect pursuing a course of action. Negative affect indicates influences choice remain unclear.1 pessimism, and the evaluation of a decision based on In this paper, we review the finance literature and potential loss. Negative affect motivates us to avoid assemble evidence that affect states influence both in- activities or situations that prompt it.
vestor behavior and market prices. Using recent find- Affect states give rise to characteristic cognitive and ings from neuroscience, we describe the neurological behavioral tendencies. Risk-related biases in financial basis of affective influences on financial decisions. In judgment have been associated with affect and named light of these new findings, we instruct readers how the "affect heuristic" (Slovic et al. [2002], Finucane, to manage disruptive affects as they arise in order to Peters, and Slovic [2003]).
improve the quality of their financial choices.
Since Aristotle, scientists and philosophers have To begin, consider the following paradox: Why do loosely hypothesized that two major brain functions people buy both insurance and lottery tickets? Insur- are fundamental to almost all human behavior: reward ance, which insulates us from unanticipated financial approach (pleasure-seeking), and loss avoidance (pain losses, is an investment with negative expected returns.
avoidance) (Spencer [1880]). These systems can be Buying lottery tickets is a gambling behavior that im- activated or deactivated independently. When we face plies the acceptance of a negative expected return in potential financial gains or losses, one or both of these the attempt to earn a larger gain. Ironically, we buy systems may be used in decision making.
insurance to avoid potential losses, and we buy lottery Neuroscience helps us understand the character- tickets to pursue potential gains, yet both purchases istics of these motivational systems and their conse- quences for our behavior. We review recent empirical Richard L. Peterson, M.D. is a Managing Partner in Market
evidence that shows the direct link between brain ac- Psychology Consulting Fairfax, California.
tivation specific to these systems, affective states, and The corresponding author is Richard L. Peterson, Managing Part- financial decision making.
ner Market Psychology Consulting, 399 Forrest Ave Fairfax, CA The paper is organized as follows. The second sec- 94930 415.267.4880. Email: [email protected] Microsoft Word tion discusses the components of the reward and loss

avoidance systems and defines affective states. The and pursuit. People who are electrically stimulated in third and fourth sections survey empirical findings on brain regions with high concentrations of dopamine the role of affect in financial markets and on trading be- terminals report intense feelings of well-being (Heath havior. The fifth section discusses some of the personal [1964]). In fact, the dopaminergic pathways of the re- consequences of pathological disruptions in the func- ward system are activated by illicit drug use, hence the 110 tionality of these systems. The sixth section discusses term "dope" to refer to street drugs. Dopamine activity the neurochemistry and genetics of risk assessment.
in the reward system appears to correlate with subjec- The final section concludes, and proposes ways indi- tive reports of positive affect (Knutson [2001b]).
viduals can make better financial choices by taking into The personality trait of extraversion is character- account the impact of affect on their decision making.
ized by both reward-seeking and sociability (gregari- 115ousness). Neuroscience researchers like Cohen et al.
[2005] have found that activation of the brain's re- Reward and Loss Avoidance Systems in
ward system is positively correlated with extraversion Decisions under Risk
scores. Cohen et al. [2005] also found that the pres-ence of the dopamine D2 receptor A1 allele correlates 120 Perceiving a potential reward in the environment with extraversion and the strength of reward system sets the brain's reward approach system into action.
activation when receiving financial rewards.
Overall, the reward system coordinates the search for, The brain's loss avoidance system is less defined evaluation of, and motivated pursuit of potential re- than the reward system. It runs through several regions wards. The neurons that carry information in the reward of the brain's limbic system, in particular the amyg- 125 system transmit signals primarily via the neurotrans- dala and the anterior insula. Its activity is mediated mitter dopamine. The reward system lies along one by serotonin and norepinephrine (among other neuro- of the five major dopamine pathways in the brain, the transmitters), and can be modulated with antidepres- mesolimbic pathway, which extends from the ventral sant medication such as selective serotonin reuptake tegmental area (VTA) at the base of the brain, through inhibitors (SSRIs). Acute activation of the loss avoid- 130 the nucleus accumbens (NAcc) in the limbic system, to ance system can lead to the subjective experience and the gray matter of the frontal lobes (MPFC) (Bozarth physiological signs of anxiety (Bechara, Damasio, and [1994]) (see Figure 1).
Damasio [2000]).
Dopamine has historically been called the "plea- Chronic activation of the loss avoidance system is sure" chemical of the brain. More recently, dopamine indicated by the personality trait of neuroticism (Floury 135 has been found to play a part in functions such as atten- et al. [2004]), which is characterized by risk aversion.
tion, mood, learning, motivation, and reward valuation The prevalence of neuroticism has been weakly asso-ciated with the short form ("s"-allele) of the serotonin transporter gene, which leads to a decrease in serotonin The Major Structural Components of the Reward
sensitivity (Arnold, Zai, and Richter [2004]).
System. The dopamine neuron cell bodies located
Amygdala activation appears to decrease when po- in the ventral tegmental area (VTA) have axonal
tential rewards are missed, showing an inverse corre- extensions through the nucleus accumbens (NAcc)
lation with punishment. The brain's insula is involved and into the frontal lobes, including the medial
in the anticipation of aversive affective and noxious prefrontal cortex (MPFC).
physical stimuli (Simmons et al. [2004]) and in selec- 145tive disgust processing (Wright et al. [2004]). Pauluset al. [2003] show that insula activation is related torisk-averse decision making. They found that 1) insulaactivation was significantly stronger when subjects se-lected a "risky" response versus a "safe" response in 150an experimental task, 2) the degree of insula activa-tion was related to the probability of selecting a "safe"response following a punished response, and 3) thedegree of insula activation was related to subjects' de-gree of harm avoidance and neuroticism as measured 155by personality questionnaires.
Kuhnen and Knutson [2005] have demonstrated the roles of the reward and loss avoidance systemsin portfolio choice and investment error. Their goalswere to determine whether anticipatory brain activity 160in the NAcc and anterior insula would predict risk-seeking versus risk-averse choices, and whether acti- AFFECT AND FINANCIAL DECISION-MAKING vating these regions would influence both suboptimal thus collectively increase their willingness to accept and optimal choices.
risk.Kamstra, Kramer, and Levi [2001] find that stock Kuhnen and Knutson's [2005] study combined a returns are significantly related to season. They ex- dynamic investment task with functional magnetic res- amine stock returns during the three months between 220 onance imaging (fMRI). Subjects' actual investment the fall equinox and the winter solstice, and the three choices during the task were compared to those of a months between the winter solstice and the spring rational risk-neutral agent who maximized expected equinox. The authors found that variations in the length profit. Suboptimal choices were defined as deviations of day contribute to stock returns. In particular, the from this model, and included both "risk-seeking mis- market underperformed in the fall quarter and outper- 225 takes" (in which people take risks when they should formed in the spring quarter. They hypothesize that not), and "risk-aversion mistakes" (in which people do affective shifts, like the seasonal mood variations of not take risks when they should).
seasonal affective disorder, can alter risk preferences Kuhnen and Knutson [2005] found that while NAcc and subsequent investment behavior.
activation preceded both risky choices and risk-seeking Krivelyova and Robotti [2003] found correlations 230 mistakes, anterior insula activation preceded both risk- between strong geomagnetic storms and world stock less choices and risk aversion mistakes. These findings market underperformance over the following six days.
are consistent with the hypotheses that NAcc activation The authors noted that the psychology literature represents gain prediction (Knutson et al. [2001b]), also demonstrates a correlation between geomagnetic while anterior insula activation represents loss predic- storms and signs of depression in the general popula- 235 tion (Paulus et al. [2003]). The results indicate that tion over the two weeks following the storms. Depres- anticipatory neural activation contributes to rational sion is an affective disorder characterized, in part, by choice and may also promote irrational choice. Thus, risk aversion.
financial decision-making requires recruiting distinct Seasonal and meteorological factors may contribute anticipatory mechanisms for taking or avoiding risks, to market price anomalies via collective changes in 240 while remembering that excessive activation of one affect (and thus risk preferences). However, the nature mechanism or the other may lead to mistakes.
of these effects is still debated. Goetzmann and Zhu Overall, these findings suggest that risk-seeking [2002] analyzed trading accounts of 79,995 investors choices (such as gambling at a casino) and risk-averse from 1991 to 1996, and found that individual investors choices (such as buying insurance) may be driven by do not trade differently on sunny days versus cloudy 245 two distinct neural mechanisms involving the NAcc days. However, the authors did note that market maker and the anterior insula. The findings are consistent behavior was significantly impacted by the degree of with the notion that activation in the NAcc and the cloud cover. Wider bid/ask spreads on cloudy days anterior insula relate to positive and negative antici- were hypothesized to represent risk aversion among patory affective states, respectively. Activating one of market makers.
these regions can lead to a shift in risk preferences. This If affect states do predict market price movements, may explain why casinos surround their guests with re- how can we measure investors' average affect in order ward cues (i.e., inexpensive food, free liquor, surprise to predict market prices? In the finance literature, senti- gifts, potential jackpot prizes). Anticipating rewards ment is the closest available measure. Both newsletter activates the NAcc, which may lead to an increase in writers (Clarke and Statman [1998]) and individual 255 investors (Fisher and Statman [2000]) show increasedoptimism about future stock market gains (bullishness)following high recent returns. Additionally, Fisher and Affect in Market Pricing
Statman [2000] found that as the S&P 500 declinedover a twelve-month period, investor optimism about 260 Over the past five years, several finance studies have the stock market's future also declined.
directly identified affective factors as likely causes of Fisher and Statman [2000] noted that the percent- market price anomalies. Cloud cover, for example, age of investors who believed the market was over- has been used as a proxy for negative affect states valued was paradoxically correlated with expectations (Schwartz [1983]). Hirshleifer and Shumway [2002] of future returns from 1998 to 2001. When investors 265 found that cloud cover in the city of a country's major perceived the market as undervalued, they expected to stock exchange was negatively correlated with daily earn lower returns. As sentiment became more opti- stock index returns in eighteen of twenty-six national mistic or pessimistic in a positive feedback relation- exchanges from 1982–1997. In New York City, there ship with past price changes, so did expectations of was a 24.8% annual return for all sunny days, and future gains or losses. Additionally, sentiment levels 270 an 8.7% average return for cloudy days. The authors appear to be negatively correlated with (and somewhat cite psychology literature indicating that sunshine in- predictive of) future market price changes (Fisher and creases market participants' positive affect, and may Statman [2001]).
Whether sentiment is a proxy for the activation of emotionally stable, introverted, and open to new ex- the reward system (bullishness) or the loss avoidance system (bearishness) remains unknown. Positive feel- Steenbarger [2003] performed personality tests on 330 ings (like optimism) are a proxy for reward system sixty-four traders at a seminar conducted by "Market activation, and it is very likely that the brain's moti- Wizard" Linda Bradford Raschke. He found that high vational systems are engaged when forecasting future conscientiousness scores (a measure of impulse con- stock market gains or losses.
trol) were the most reliable predictor of trading success,but that high openness and high neuroticism were cor- 335related with trading problems. He summarizes these Emotions and Personality in the Trading Pit
findings as "one important lesson: Success in tradingis related to the ability to stay consistent and plan- Several researchers have investigated the psycho- driven." Emotional stability and impulse control tend logical origins of successful and unsuccessful trading.
to correlate with successful trading.
Quantifiable differences have been found between the personality traits and emotional reactions of successfulversus less successful traders. Personality traits rep- Financial Decisions and Mental Health
resent affective coping and impulse control strategiesthat differ from individual to individual. We previously The neural origins of financial risk-taking can discussed the personality trait neuroticism as a func- be partially understood by examining the underlying tion of the loss avoidance system. The personality trait pathologies and treatments of individuals who exhibit extraversion is correlated with optimism, an affect as- disordered financial behavior. Some mental illnesses, 345 sociated with reward system activation. Preliminary as defined by the Diagnostic and Statistical Manual neuroscience evidence has suggested that extraverts IV-TR (American Psychiatric Association [2000]), re- have more sensitive reward systems during financial sult in abnormal financial behavior. Brain lesions in the gain processing (Cohen et al. [2005]).
orbitofrontal cortex, a processing center of the reward Lo and Repin [2002] took psychophysiological system, have been found to result in specific abnor- 350 measurements from ten traders during real-time intra- malities in financial decision making (Damasio [1994], day trading and found that traders experienced physi- Shiv et al. [2005]). Taken together, these findings shed ological reactions during periods of market volatility.
some light on the fundamental mechanisms of financial They also showed that less experienced traders had decision making.
significantly greater physiological reactions to mar- Acute mania is a pathological mood state typically 355 ket volatility than their more experienced colleagues.
characterized by euphoric mood and excessive risk- The authors concluded, "Contrary to the common be- taking (including with money). Some manic patients lief that emotions have no place in rational financial who have access to brokerage accounts will rapidly decision-making processes, physiological variables as- trade stocks, often until the account is drained. One sociated with the autonomic nervous system are highly website notes that some manic patients "go on shop- 360 correlated with market events even for highly experi- ping sprees, spend food money to buy lotto tickets, or enced professional traders." try to make a killing in the stock market" (Bernhardt In a subsequent study, Lo, Repin, and Steenbarger [2005] examined the trading patterns, personality char- Mania is caused by overactive dopaminergic cir- acteristics, and daily affective reactions of eighty cuits in the brain, including the mesolimbic circuit of 365 traders over twenty-five trading days. Only thirty-three the reward system. Treatments for mania include an- of the traders completed the study, in part because of tipsychotic medications that directly block or limit the a 20% market decline during the study period. The au- neural stimulation caused by dopamine release. But thors concluded that personality traits themselves are these treatments are often rejected by patients because not important for trading. However, they did find a cor- they also dampen the euphoric high that accompanies 370 relation between the strength of affective reactions and an acute manic episode.
poor trading performance. They conclude, "Our results For another example, consider that the lifetime show that extreme emotional responses are apparently prevalence of pathological gambling disorder in the counterproductive from the perspective of trading per- U.S. is less than 3.5% (American Psychiatric Associa- tion [2000]). Recent neuroimaging studies demonstrate 375 The big five personality traits – extraversion, consci- a hypoactivity of the reward circuitry in these individu- entiousness, neuroticism, openness, and agreeableness als. Pathological gamblers often gamble to "feel excite- – are directly related to styles of affective processing ment," which they achieve by activating their patholog- and impulse control. Fenton-O'Creevy et al. [2004] ically desensitized reward circuits.
conclude from a study of 118 professional traders at Pathological gambling is often treated with naltrex- 380 investment banks that successful traders tend to be one (Kim et al. [2001]), a medicine that blocks opiate AFFECT AND FINANCIAL DECISION-MAKING receptors. In the reward system, mu opiate receptors have shown success in treating hoarding (Saxena and stimulate dopamine release (Di Chiara and Imperato Maidment [2004]).
[1988]). Blocking opiate receptors with naltrexone de- creases dopamine release in the nucleus accumbens,which results in decreased subjective feelings of plea- The Neurochemistry of Risk Assessment
sure (Jayaram-Lindstrom et al. [2004]). Gamblers tak-ing naltrexone are not compelled to seek reward sys- An article written by a psychiatrist in February tem stimulation through further gambling, possibly be- 2000 was headlined "Is the Market on Prozac?" (Nesse cause they feel reduced pleasure from gambling.
[2000]). The article noted that prescriptions for psy- Some subtypes of depression, such as "melan- choactive drugs increased from 131 million in 1988 to 445 cholic" depression, correlate with decreased dopamine 233 million in 1998. The author went on to speculate, activity in the reward pathway. Melancholic depression "I would not be surprised to learn that one in four large also correlates with anhedonia (lack of pleasure), ex- investors has used some kind of mood-altering drug." cessive sleepiness, and chronic risk aversion, including He also remarked that some of his patients on SSRI in the financial markets.
medications "report that they become far less cautious 450 One patient in treatment with this author for depres- than they were before, worrying too little about real sion kept all her assets in cash. Because of her fear of dangers." He wondered whether the clear disregard financial risk, she was reluctant to invest in U.S. gov- for risk among many investors at that time was partly ernment bonds because she believed the government attributable to the use of common antidepressant med- might default on payments. These thought distortions were directly related to her depressive illness and its In fact, many executives are rumored to refer to neurochemical basis. Successful treatment with antide- Prozac as the "teflon-medicine," because it allows them pressant medications was followed by small, tentative to look past perceived threats, decide quickly without purchases of bonds and mutual funds.
ruminating, and remain more optimistic during stress.
The role of anxiety in biasing financial decisions is In his bestselling book, Listening to Prozac, psychia- 460 less clear-cut than for mania, pathological gambling, trist Peter Kramer [1993] frets about the potential use and depression. Pathological anxiety is characterized of SSRI antidepressants as "steroids for the business by exaggerated risk perception and hypervigilance. At higher levels, anxiety may lead to panic and the psy- Knutson et al. [1998] gave normal subjects ther- chophysiological "fight or flight" response (e.g., "panic apeutic doses of the antidepressant paroxetine (an 465 selling"). Whether the "fight" or the "flight" response SSRI). Knutson's subjects experienced a reduction in is triggered depends on past experiences, personality threat perception and an increase in affiliative behav- traits, anxiety intensity, and learned coping strategies.
iors. In another study, subjects given the SSRI med- Isolated mild anxiety leads to an overall reduction in ication citalopram showed decreased amygdala (fear- related) activations on fMRI (Del-Ben et al. [2005]). 470 Anxiety can lead to either impulsive overtrading, or The characteristics of decreased threat perception and paralysis and avoidance of the markets. If the reward increased social affiliation mirror the decreased risk system is overactivated along with the loss avoidance perception and herding of excessively bullish investors.
system, obsessive overtrading may result. If the re- It is as if bubble investors are experiencing a partial de- ward system is underactivated, paralysis and passive activation of their brains' loss avoidance systems.
anxiety may occur. Mild anxiety and neuroticism cor- In addition, amphetamines are known to increase relate with a paucity of serotonin function throughout the brain's extracellular concentration of dopamine.
the brain (Floury et al. [2004]). These disorders are Neuroimaging data collected by Knutson et al. [2004] often successfully reversed with serotonin-enhancing suggest that amphetamines modulate dopamine sig- medications like fluoxetine (Prozac).
nals in the NAcc area of the reward system. Anec- 480 Two mental disorders on the obsessive-compulsive dotal reports indicate that time-release amphetamine- spectrum merit discussion as well. First, compulsive derived medications have been used by poker play- shopping disorder is currently assumed to reside on ers to win millions of dollars in tournaments. "With the obsessive-compulsive/anxiety spectrum of disor- Adderall [an amphetamine derivative] in my system, I ders, but its legitimacy as an independent mental ill- am like an information sponge, able to process data 485 ness is still being debated. Moderately successful treat- from several players at once while considering my ment has been achieved with the SSRI antidepressant next action" (Phillips [2005]). The author speculates (citalopram) (Bullock and Koran [2003]). Second, the that the increased focus and wakefulness promoted by disorder of hoarding, whereby sufferers accumulate ex- amphetamines aids poker playing.
cessive quantities of one type of good or asset, is also Some medications directly alter risk/return percep- 490 considered a subtype of obsessive-compulsive disor- tions in behavioral experiments. Rogers et al. [2004] der. Only behavioral and psychotherapy approaches report that a common high blood pressure medication in the beta-blocker family decreased experimental sub- (Goleman [1998]). For example, according to Schwa- jects' discrimination of potential losses during a risky ger [2003], Steve Cohen, the principal of SAC Capital, task. "Propranolol [a beta-blocker] produced a selec- is "unquestionably one of the world's greatest traders." tive change in volunteers' decision-making; namely, it SAC Capital has a former Olympic psychiatrist, Ari significantly reduced the discrimination between large Kiev, M.D., on staff to assist traders in improving 550 and small possible losses when the probability of win- performance. The use of a psychiatrist by one of the ning was relatively low and the probability of losing world's greatest traders certainly supports the notion was high" (Rogers et al. [2004]). Propranolol is also that psychological management can benefit financial one of the most common treatments for "stage fright," risk-takers. It may even suggest that people need psy- and is occasionally used to treat other types of anxiety chological support to prevent themselves from suc- 555 and aggressive impulsivity.
cumbing to the most common cognitive, behavioral, Perhaps not surprisingly, other drugs have also been and affective biases.
shown to affect financial decisions. Lane et al. [2005a] While observing Steve Cohen trade, Schwager designed an experiment in which subjects were given [2003] is "struck by his casualness." Schwager notes, a choice between a certain low-value positive expected "He also seemed to maintain a constant sense of humor 560 value option ($0.01) or a zero expected value option while trading." Cohen's sense of humor and casualness with high return variability (the risky option). THC- demonstrate that he isn't taking his trading gains and intoxicated subjects preferred the risky option signifi- losses "to heart." So how can the average financial de- cantly more than control subjects who had been given cision maker maintain such an emotional balance and a placebo. Additionally, if they lost money after select- healthy state of mind? ing the risky option, THC-intoxicated subjects were One method of cultivating dispassion about finan- significantly more likely to persist with it, while con- cial performance is to maintain non-judgmental beliefs trol subjects were more likely to move to the positive and flexible expectations. In particular, practitioners expected value option.
must realize that not every decision requires abso- Lane et al. [2004] found a similar preference and lute perfection or they will invariably be disappointed. 570 persistence with the risky option in alcohol-intoxicated George Soros [1995] provides an excellent example.
subjects when compared to controls. Deakin et al.
Referring to his well-publicized philosophy, "belief in [2004] showed that a dose of the benzodiazepine val- fallibility," he says, "To others, being wrong is a source ium increased the number of points wagered in a risk- of shame. To me, recognizing my mistakes is a source taking task in only those trials with the lowest odds of of pride. Once we realize that imperfect understand- 575 winning but the highest potential payoff. Lane et al.
ing is the human condition, there's no shame in being [2005b] found that administration of the benzodi- wrong, only in failing to correct our mistakes." azepine alprazolam produced increased selection of a Soros is thus protected from a crisis of confidence.
risky option under laboratory conditions. The strength For most people, the possibility of being wrong is of subjects' risk-seeking personality traits may be pre- threatening and can cause anxiety. As Cymbalista 580 dictive of how drugs affect their risk-taking behavior [2003] notes, "The difference between Soros and most (Lane et al. [2005b]).
other traders is that he accepts fallibility, so he starts These studies illustrate that common chemical out by assuming his hypothesis is wrong, rather than compounds can alter an individual's propensity for right like almost everyone else." By maintaining a be- risk. In particular, frequently prescribed antidepres- lief in fallibility, Soros remains open-minded about his 585 sants and anxiolytics (SSRI medications) appear to positions, and can minimize denial, disappointment, decrease threat perception and increase social affili- and anger if he learns his decisions were wrong.
ation. Time-release amphetamines increase alertnessand smooth the reward system's reactivity to potential Investor, Heal Thyself
financial gains. A common hypotensive medication (abeta-blocker) decreased aversion to potential financial Financial practitioners can improve their financial losses. Findings regarding alcohol, marijuana, and ben- decision making by learning to interpret and man- 590 zodiazepines suggest these drugs increase risky finan- age affect states. With adequate self-awareness, affect states can be viewed as internal signals. As seen fromthe examples we cite here, investors are most likely tomake subpar financial decisions if they are emotion-ally reactive or have poor impulse control. In either 595 How to Make Better Financial Choices
case, a dysfunction of the reward or loss avoidance sys-tems is likely to result. The affect states that can arise are conditioned by our past experiences, the vividness The use of psychological techniques to improve per- of the potential consequences, innate genetic endow- formance in the business world is increasing rapidly ments, and personality (among many other factors). As 600 AFFECT AND FINANCIAL DECISION-MAKING demonstrated in Kuhnen and Knutson [2005], strong Additionally, note that successful financial practi- affects threaten to override rational decision making tioners systematize as much of their decision-making and should be appropriately managed for optimal per- as possible. Professionals are prepared for contingen- 660 cies, and they approach mistakes with curiosity, rather In clinical psychology, there are a plethora of strate- than dread, fear, or denial. As Lo and Repin [2002] find, gies for regulating affect states. Use of these strategies experienced professionals are less reactive to market may benefit financial practitioners who find themselves volatility than novices, which may be due to a classical overwhelmed by affect (fear, euphoria, greed, panic, conditioning process or their internal beliefs.
etc. . ) during their investment decision-making.
The brain's two motivational systems evaluate po- The first step in managing affects is to become aware tential gains and losses independently. We are likely to of them. Biais et al. [2000] found that "highly self- experience relatively strong affects when one system is monitoring" traders perform better than their peers in dominant and are prone to making irrational financial an experimental market. While it is important to notice decisions. Our only clue to a personal condition of im- 670 affect states, it is crucial to avoid placing any value balanced motivational systems lies in our affect states.
judgment on them. Judgments such as "I shouldn't If we learn to become self-aware, we can perceive when be feeling this" or "I'm really good at this" interfere one system is out of balance. Self-awareness, cultivat- with the exercise and give rise to further affective reac- ing a "belief in fallibility," exercising techniques of tions (annoyance, disgust, anger, frustration, and self- affect management, and visualizing and practicing dif- 675 congratulation, to name a few).
ficult decision situations can all assist in minimizing Some common causes of affective reactions among the irrational and costly impact of financial emotions.
financial decision makers include the size of the po- We can take action and learn to be more profitable.
tential reward or loss (Knutson et al. [2001b]), thevividness of potential consequences (Loewenstein et al.
[2001]), and any counterfactual comparisons it rep- resents (Mellers, Schwartz, and Ritov [1999]). Learnwhat financial situations cause affect to arise. Too of- Based on the research we summarize here, it is ap- 680 ten, affect is left unnoticed and unattended. Place the parent that recent financial gains and losses change feelings in a context, and then practice noticing what investor behavior. Financial market participants need automatic behaviors you associate with them.
to monitor their own internal reactions to see how their Meditation, peaceful reflection, and contemplation decisions are biased by their recent experiences, and are other disciplines that can be used to improve they must be careful not to let such biases affect deci- 685 self-awareness. Financial practitioners should practice sion discipline.
noticing the thoughts, feelings, and attitudes that un- In particular, investors who have experienced a re- derlie their decision-making. They can search for pat- cent loss may note feelings of nervousness and/or other terns, relationships, and emotionality, impulsivity, or signs of irrational risk avoidance behavior like hesita- irritability in these thoughts and feelings. In particular, tion in entering new positions, excessive deliberation 690 when observing greed and fear, ask yourself: "What about further potential losses, and seeing more finan- causes this? Where did it come from? What is it re- cial threats than usual. They must take special care not lated to?" By placing the affective information in a to let that anxiety affect future discipline in trading personal context, you can become familiar with your "triggers" and use awareness of your emotional state Conversely, investors who have recently earned 695 to generate a personal warning signal. By understand- large gains may be feeling celebratory, extremely intel- ing and contextualizing your emotions, you can more ligent, or somewhat invincible. They must also make easily detect potentially weak decision situations when sure not to focus solely on potential returns and ig- nore the risk control and monitoring aspects required Self-discipline, a facet of the personality trait con- in making financial decisions.
scientiousness, relates to impulse management. It is es- Not everyone can maintain a disciplined investment sential to interrupting the automatic flow among emo- strategy during the simultaneous gains or losses that ac- tions, thoughts, and behaviors. Self-disciplined people company stock market fluctuations. Our research sug- are better able to control and channel their impulses gests that investors' undisciplined decisions may be toward goals. They can identify and delay acting upon biased in a way that furthers the development of bull 705 their affects. To illustrate, we note that a survey of 600 and bear markets. When the stock market is rising and foreign exchange traders in Europe and the U.K. by most people are experiencing paper gains, many feel Oberlechner [2004] asked traders to rank the most im- hypomanic, they ignore risks, and they overempha- portant characteristics for professional success. From a size potential returns. Consequently, the market risk list of twenty-three, "disciplined cooperation" ranked premium tends to decline and stocks rise further, gen- 710 the highest.
erating more upward movements in the bull market.
When the stock market is falling and most peo- in Male Volunteers." Psychopharmacology (Berlin), April, 173, ple are incurring paper losses, many become anxious, 1–2, (2004) pp. 88–97.
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