Released in December 2010 as part of the Behavioral Finance and Investment Management monograph, “Eight Lessons from Neuroeconomics for Money Managers” by Steven G. Sapra, CFA, contains many timeless insights to help investment managers make better choices. Unlike many behavioral finance pieces which simply contain behavioral admonitions, “Eight Lessons” actually contains prescriptions for overcoming common errors of judgment.
As an example of the piece’s rich substance, the first lesson, “Anticipating Rewards,” discusses how receiving rewards is pleasurable. Researchers have demonstrated that achieving investment returns provides a similar high to drugs of abuse. Just like a drug, when the pleasure associated with the reward wears off, the brain requires that we acquire more of the good that caused such pleasure. Unfortunately, this cause-and-effect chain can lead to excessive risk taking.
To break the chain, it is important to gain conscious awareness of brain function. This is done using the energetically taxing, yet necessary, willpower of the prefrontal executive regions of the brain. Only then can the evolutionary urges of anticipating rewards be overcome.
“Eight Lessons from Neuroeconomics for Money Managers” contains seven additional potent teachings well worth understanding:
- Balancing Risk: Different regions of the brain process rewards and risks. In turn this may lead to a lessening of risk aversion as professional money managers become inured to the brain’s avoidance signal. Conversely, in highly trending markets, investment managers may take on too little risk.
Recommendation: Sapra recommends that firms have systems in place to alert them if investment decision makers are taking on either too much or too little risk. For example, supervisors could receive a daily risk report on each trader.
- Wait for It: Humans are the only animal known to delay gratification using willpower. However, to do so takes tremendous effort and energy. In high-stress, fast-moving market situations the brain is taxed, and decisions that lead to immediate gratification are more likely to be undertaken. An example would be selling an asset with a disappointing price performance.
Recommendation: It is recommended by the author that in high-stress and high-volatility situations decisions are delayed until after the anxious period has passed.
- Following the Herd: People have a hard time breaking away from herd thinking. Unfortunately when we choose to swim upstream against the market it triggers feelings of aloneness and vulnerability.
Recommendation: Sapra suggests that investment professionals should always remain conscious of their desire to be a part of the crowd and should ask themselves whether each investment decision is driven by independent analysis or a desire to be in vogue.
- The New New Thing: Brains often confound novelty and reward, leading to confusion during investment decisions. Thus, any new information is likely to trigger feelings of reward. Unfortunately, without consciousness of this mechanism, investors may find themselves seeking ever-greater information, leading to excess risk taking and cognitive overload.
Recommendation: Turn off or away from sources of information, such as data terminals, e-mail, or the Internet when making decisions. Making decisions while relaxed (i.e., listening to music), can often lead to better decisions. Of course, scaling down the pressure in the news-flow fire hose is also a solution for improved decision making.
- Checking References: This lesson addresses the well known cognitive error of reference points, in which comparisons are made relatively, leading to a misunderstanding of the absolute value of the thing being analyzed (e.g., call option, CDS, CMO tranche, equity, etc.).
Recommendation: Avoid making decisions in reference to recent gains or losses. Instead, Sapra suggests, make decisions as guided by an investment thesis or previously chosen stop-loss or limit orders.
- Rational Rationality: Familiarity often leads to quick decisions and the inability to see a new situation for its uniqueness. Investment veterans often put less effort into decision making than less experienced peers as their brains economize on energy output when a situation seems similar to those encountered in the past.
Recommendation: The author suggests making decisions in a new place or in a new way. For example, make the decision outside the office if the decision is normally made inside. Sit at a different desk, or take a walk, take a vacation, or read different kinds of books. Do anything to get the brain unlocked from its familiar modes.
- Portfolio Love: We tend to anthropomorphize the inanimate and consequently develop feelings of attachment to our investments and our choices. Consistent exposure leads to familiarity and then to feelings of attachment. A sure sign that this has occurred is if you have a nickname for an investment.
Recommendation: Have an investment professional who was not part of the decision-making process be the one to manage the portfolio. Sapra also recommends quantitative asset management in which trading decisions are driven by computer models as a way of overcoming “portfolio love.”