Why do investors act that way?

We are entering the traditional "tough" periods of the market calendar, September and October. As a result, many investors may react unreasonably and even want to alter their well-structured portfolios. Why do we change our normal behaviour when it comes to investing? Although we know we shouldn't, we are still compelled to do the wrong thing at the wrong time. We continue to buy high and sell low. We panic and become guilt ridden. Why do we react in this way? The theory of neuroeconomics takes a biological approach to understanding these impulses.

What is neuroeconomics?

Neuroscientists and economists theorize that we revert to mania when making certain financial decisions because of unconscious core patterns our brain exerts on our behaviour. These patterns reside deep in the less-developed areas of the brain, where the urges to eat and reproduce are found. Since these impulses aren't well restrained, they can often wreak havoc with our finances.

In "Mean Markets and Lizard Brains," economist Terry Burnham states: "There are biological causes for irrational financial behavior, and it's why panics and crashes happen." He adds, "Those who are the most successful at amassing capital, making money, are people who have systems in place to guard against 'emotional decisions', use quantitative analysis and are extremely disciplined. Many times, these people use a team approach to managing finances."

The basic notion of neuroeconomics, which goes back to Plato, is that a battle is occurring inside our brains. In recent years, the rational and the emotional parts of the brain have been identified through neuro-imaging. The prefrontal cortex (above your eyes) is where analytical calculations take place and the back of the brain, 'the lizard brain', contains the more primitive structures of the brain.

The lizard brain explained

"Compared to other animals, humans have extremely large prefrontal cortexes, which explains our superior reasoning ability," says Burnham. "Yet, since the lizard part is 'more involved than we suspect'; we not only make errors and fall into traps, but also create a cohesive story about our own behaviour, which makes it harder to understand the sources of our own actions."

We possess this configuration because the human brain was shaped in the Pleistocene era, when humans had to forage for food. Besides sabotaging our investing instincts, it can contribute to obesity, drug addiction and poverty.

Why the lizard brain takes over

"Our brains, like our bodies, reflect the world of our ancestors. In particular, our lizard brains are pattern seeking, backward-looking systems that used to allow us to forage successfully for food, and repeat successful behaviors. This system helped our ancestors survive and reproduce, but financial markets punish such backward-looking decisions. Consequently, our lizard brains tend to make us buy at market tops and sell at market bottoms," writes Burnham. "The lizard brain is not stupid, but when confronted with problems never experienced by our ancestors it can make us look crazy and cost us money."

As an example of how the lizard brain affects us, consider how investors tend to seek patterns from the past. In a world where humans spent much time hunting and dealing with nature, the past was often the best predictor of the future. For thousands of years, we could forecast the outcome of a hunt by observing an animal's footprints. Our brain is constructed to locate patterns. Studies have shown that if you flip a coin in front of a person, the more times heads comes up, the more surprised the brain is when tails turn up. Although the person knows that the coin toss is fair, the lizard brain is saying, "Well, it's been heads eight times out of ten, so heads are more likely to come up." When tails finally appear, that part of the brain says, "Whoa. We were expecting heads." Similarly, if you believe a certain stock or industry will go up this year because it went up last year, you may be disappointed.

The lizard brain extrapolates from the past and applies it to the present. You believe you have found a reliable relationship between two factors, so that when the Federal Reserve decreases the gold supply you buy gold-mining companies. You assume that when a company's share price is rising it will continue to go up. You suppose that trouble in the Mid-East will cause oil to go up, resources will continue to do well, (since they have in the past three years) and that house prices in Canada will continue to rise at the same rate.

So it appears that our brains are our own worst enemies. Burnham summarizes: "We need to precisely restrain our instincts in order to make money. Unlike neutral games of chance, or ancestral problems like gathering and hunting, financial success means suppressing our 'gut' instincts."

Dealing with it

Our advice to improve your financial health is: Give your lizard brain a break, stop verifying your portfolio's value and examining the financial news on a regular basis. By the time you get the information, it will be too late; there will be no trading value. Worse still, your lizard brain may misinterpret random news, compounding your mistakes.

Instead of trying to discover outperforming funds, focus on taking the appropriate risk and ensuring your portfolio is managed by specialists, well diversified and rebalanced. In other words, strive for a portfolio structure that allows as little emotional intervention as possible. Once you have built a sound investment strategy, modifications should occur only when your goals and needs change. A recent MIT study of professional traders confirms this theory. The least emotional among them were the most successful.

Burnham also declares, "By understanding and taming the lizard brain, you can position yourself to prosper in financial markets that often seem downright mean. If you go through and you study the Warren Buffetts of the world and the people who are amassing capital in the world, who are making money in markets, those people have systems in place to not allow their lizard brain to bankrupt them. They don't use impulse, they use quantitative analysis, they use discipline, they use team approaches, a whole range of tactics to constrain their instincts and their emotions."

Many of us become overly consumed by the funds, sectors, and countries that are excelling; this is the reaction of our lizard brains. Admitting that part of your brain is working against you is not a sign of weakness, but rather the first step toward succeeding in financial markets.