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Neuroeconomics: Brain Damaged Investors

Sunday, July 24, 2005 | 11:11 AM

We've discussed the importance of not becoming emotionally involved with investing or a trade or even the entire market. Now, a new study of aphasiacs -- a kind of brain damage affecting only specific regions of the brain -- turn out to make better investment decisions than people with "undamaged" brains.

The study shows "people with brain damage that impaired their ability to experience emotions such as fear outperformed other people in an investment game."

The (obvious) conclusion is that mixing emotion with investing can lead to bad outcomes:

"By linking brain science to investment behavior, researchers concluded that people with an impaired ability to experience emotions could actually make better financial decisions than other people under certain circumstances. The research is part of a fast-growing interdisciplinary field called "neuroeconomics" that explores the role biology plays in economic decision making, by combining insights from cognitive neuroscience, psychology and economics. The study was published last month in the journal Psychological Science, and was conducted by a team of researchers from Carnegie Mellon University, the Stanford Graduate School of Business and the University of Iowa."

Quite simply, if you can avoid your own instincts when investing or trading, you remove a source of underperformance.

My favorite exposition on this topic comes from Michael Mauboussin back when he was at Credit Suisse First Boston, titled "What Have You Learned in the Past 2 Seconds?"

The bottom line is that learning to control your "emotional responsiveness" is an advantage when investing. You are more willing to take calcualted gambles with high payoffs when you control fear. Too much cautious and being overly reactive to your emotions will hurt your performance:

"Some neuroscientists believe good investors may be exceptionally skilled at suppressing emotional reactions. "It's possible that people who are high-risk takers or good investors may have what you call a functional psychopathy," says Antoine Bechara, an associate professor of neurology at the University of Iowa, and a co-author of the study. "They don't react emotionally to things. Good investors can learn to control their emotions in certain ways to become like those people."

Neuroeconomics helps explain why don't people always act in their own self-interest: Its because they are often irrational.

Before you start whacking yourself in the head with a cast iron skillet to improve your returns, understand that this is a very specific type of injury with a peculiar brain damage; Merely giving yourself a blunt head trauma could accidentally lead to a career in economics, not money management.

Source:
Lessons From The Brain-Damaged Investor
Unusual Study Explores Links Between Emotion and Results;
'Neuroeconomics' on Wall Street
JANE SPENCER
THE WALL STREET JOURNAL
July 21, 2005; Page D1
http://online.wsj.com/article/0,,SB112190164023291519,00.html