Why Does the Human Brain Have Heightened Response to Money Issues?
The human brain evolved with its most important purpose to stay alive in a primitive world. The brain goes about survival by regulating our temperature, our heart rate, and other bodily functions. Our brains are constantly scanning for threats and rewards to keep out of harm’s way. When confronted with a serious, potentially fatal threat, the brain elicits the “fight or flight” response, activating the brain’s “survival mode.” It is not surprising then that the human brain is not necessarily well-equipped to deal with financial markets.
The issue isn’t how the brain responds to a potentially life-threatening circumstance, but that the brain responds with remarkable similarity to other circumstances that are not life-threatening. The same automated neural responses that occur when we see a wildebeest running at us full speed in nature are mirrored during certain social situations. Most interestingly, and possibly more troubling, the brain has an equally heightened response to losing money.
Understanding How and Why
As storied money manager Ken Fisher writes in The Only Three Questions That Count, before making any investment decision, we should be asking ourselves “what the heck is my brain doing to blindside me now?” Understanding how and why people behave the way they do is paramount to understanding how markets work and will allow investors to better insulate themselves against the biases we humans have and mistakes we make when faced with uncertainty. Investing is as much about lowering one’s error rate as it is about taking advantage of opportunities. Our brains are brilliant (Albert Einstein developing the theory of relativity) and limited (Albert Einstein misplacing his keys for hours at a time) simultaneously.
Our brains have many biases, which can be both irrational and predictable and occur frequently with astounding regularity. Or, as Dan Ariely would say, our minds are “predictably irrational.” Most people experience “overconfidence bias” from time to time when one’s confidence in one’s abilities or judgment exceeds actual abilities or accuracy of the judgment. Another bias is called “the halo effect,” where attractive, confident people are judged more favorably than they otherwise would be if they looked like the average individual.
Relying on Immediate Examples
We often refer to the “availability heuristic” more frequently than we would like as well, where we rely on immediate examples that come to mind when attempting to determine the likelihood of an event. One of the more relatable examples is when an airplane crashes and the resulting media frenzy influences thoughts about the safety of flying, In fact, one may even decide to drive that 6-hour trip as opposed to flying it because of the brain’s ability to retrieve quickly the image of the plane crashing from the news story you just watched.
Our minds are intuitive. And, intuition is littered with biases. As Daniel Kahneman points out in his tour de force Thinking, Fast and Slow, “the confidence we have in our intuitive beliefs and preferences is usually justified. But not always. We are often confident even when we are wrong, and an objective observer is more likely to detect our errors than we are.”
Two Modes of Thinking
In the book, Kahneman breaks down the two modes of thinking we all employ throughout our lives. While many labels have been applied, Kahneman prefers to keep it simple and “refers to two systems in the mind, System 1 and System 2. System 1 operates automatically and quickly, with little or no effort and no sense of voluntary control. System 2 allocates attention to the effortful mental activities that demand it, including complex computations. The operations of System 2 are often associated with the subjective experience of agency, choice, and concentration.”
To put it more concisely, System 1 is “fast, intuitive, and emotional.” System 2 is “slower, more deliberative, and more logical.” Making important financial decisions with System 2 seems like the logical choice for rational decision making. Unfortunately, System 1 usually overrules System 2!
Jonathan Haidt, the author of The Happiness Hypothesis, describes the two systems in an easy to understand manner: “The mind is divided in many ways, but the division that matters is between conscious/reasoned processes and automatic/implicit processes. These two parts are like a rider on the back of an elephant. The rider’s inability to control the elephant by force explains many puzzles about our mental life, particularly why we have such trouble with a weakness of will. Learning how to train the elephant is the secret of self-improvement.”
In short, System 1 is the elephant, and System 2 is the rider. Our goal is not to ignore the elephant. Too often, we are told that emotions are counterproductive. Emotions are real, and trying to suppress them is not the answer. The rider and the elephant need each other. The elephant without the rider can be too easily excitable and temperamental. The rider without the elephant would lack passion and become apathetic.
Maintaining Proper Balance
Our goal as holistic wealth management advisors is to help maintain the proper balance between System 1 and System 2 and navigate the uncertain financial markets with clear and thoughtful decision-making. We must take into account different client comfort levels regarding risk and construct “all-weather” portfolios, not only during a year like 2017 where returns were robust, and volatility was muted but also during the 4th quarter of 2018 where global stock indices were on the precipice of entering bear-market territory.
In summary, our purpose as advisors is to stay rational during turbulent times and to stay level-headed during frothier times both in terms of the financial markets and each client situation. Life is not linear, and while there will be setbacks and obstacles on the journey, we are dedicated to developing financial plans and investment portfolios that provide peace of mind and stability, allowing clients to pursue their most fulfilling life.