Neuro finance and Investment Decisions
Usually we find that investor’s behavior is affected by certain emotions. Optimistic expressive states such as enthusiasm leads to risk taking behavior and to be overconfident in their capacity to estimate investment choices as compare to pessimistic emotions such as nervousness have the contradictory effects like over investigation, framing etc. Beliefs also play important role in identifying any decision-making process. Beliefs are mental state which forces to continue an optimistic expressive state by overlook that piece of information which contradicts with individuals’ prior choices. Cognitive Dissonance is one behavioral bias developed because of beliefs and the discomfort developed at the time of contradiction of belief and the latest information. The physiological process of developing such cognitive dissonance in investment environment can be well explained in form of Neuroefinance.
Now we will discuss above mentioned feelings like overconfidence, risk aversion, mental accounting, anxiety etc. with reference to neurophysiology and their implication on investor behavior.
Neuroscience deals with the structures and secretion from brain responsible for investor behavior.
Brain secretions responsible for Investor behavior
Role of Dopamine Dopamine is a chemical secreted in brain at the time of a feeling of pleasure. More quantity of dopamine is secreted at the time of unexpected profits earned easily. At the same time when investors face an unexpected loss, the secretion of dopamine completely stops, and the person feels depressed.
Suggestion on Investment Decisions
As Dopamine is responsible for the feeling of pleasure and depression, dopamine influences the risk-taking behavior of investors. Dopamine secretion rests on an increased level when the predictions made by investors are bringing gains to him, whereas dopamine level reduces to a great extent if the predictions bring losses. Dopamine is responsible for behavioral biases like Herd Behavior, Overconfidence and Optimism in the investors.
Role of Serotonin Serotonin is a transmitter available in central nervous system and digestive tract. Serotonin is responsible for the feelings of anxiety, depression and appetite.
Suggestion on Investment Decisions
Level of Serotonin reduces at the times of unfulfilled expectations like, investment losses. Such situations lead to depression, anxiety and loss of hunger in the investor. Under the influence of deep anxiety, investor may take erratic decisions to avoid losses and depression, but it may further lead to multiplied losses and high transaction costs.
Reduced levels of serotonin cause investors to sell winning positions too early. Loss Aversion may be a result of reduced levels of serotonin.
“Take the money and run” is the tendency developed because of reduced supply of serotonin.
Brain structures responsible for Investor behavior
Role of Amygdala Almond shaped body situated in brain’s temporal medial lobe is responsible for feeling of emotions like fear, pleasure, developing phobia and post-traumatic stress. Amygdala is responsible for “fight or flight” behavior of investors.
Suggestion on Investment Decisions
Selling behavior of investors in falling markets are due to functioning of amygdale. Investors want to flight away from the falling markets because of the feeling of fear, but it is the time to fight with the bear phase and add some fundamentally strong stocks at corrected value.
Role of Prefrontal Cortex The prefrontal cortex of brain is responsible of complex cognitive decision making in social behavior and expression of personality. The prefrontal cortex is responsible for memorizing, analyzing and drawing conclusions from different situations.
Suggestion on Investment Decisions
Whenever investors commit cognitive errors, it means that prefrontal cortex does not have proper data in form of accurate, appropriate and update information for drawing decisions. Education in form of either self-education or advice of professional advisor is required to provide proper data to prefrontal cortex to have a better decision making.
Role of Nucleus Accumbens and Anterior Cingulate Nucleus Accumbens is a group of neurons located behind the ears of a human being. This group of neurons plays a role in developing addictive behavior.
Anterior Cingulate, which is the frontal portion of cingulated cortex plays important role in reward anticipation and decision making.
Together, the nucleus Accumbens and anterior cingulated help people to identify patterns and evaluate alternatives.
Suggestion on Investment Decisions
As the nucleus accumbens and anterior cingulate are responsible for patterns, they make investors to believe on trends without seeking any detailed explanations.
For Example: if a company is declaring every quarter that they have increased their earnings estimates and with the response of this information the prices of stock increases in the market. Now after every quarter the above two parts of human brain will make a pattern that after every quarter the price of stock are going to show a jump, without making any detailed fundamental analysis about the stock. Also, this has been observed that most of the investors commit the errors of pattern recognition in investment and prone to miss the investment opportunity in case of companies which have inconsistence earnings.
The New Era of Finance: Neurofinance and Investment behavior
International Journal of Research in Finance and Marketing (IJRFM)
Vol. 6 Issue 7, July 2016 (excerpt)
Dr. Priya Jinda & Shilpa Bahl
Managing IA's 