Last Updated Feb 10, 2010 11:42 PM EST
Human loss aversion
It's long been known that human beings are loss averse to an irrational degree. For example, most people reject a 50/50 gamble of losing $15 vs. gaining $20, even though it has a positive expected outcome.
According to this study, Neuroscientists have discovered the brain area responsible for fear of losing money. The research indicates that our loss aversion is triggered in the brain's amygdala, two almond-shaped clusters of tissue located in the medial temporal lobes.
The CalTech researchers compared the willingness to take risk between two groups of participants. One group had previous damage to their amygdala while the others had normal amygdala. Those with damaged amygdala were far more willing to take rational risks than the normal group.
Take this study with a grain of salt
Asking someone whether they would take a gamble and actually having them do it are two different things. This hypothetical versus actual dilemma brings to mind the risk surveys often administered in my profession. Asking my clients the intellectual question of how they would feel if their stock portfolio lost half their value, gets a distinctly different response than actually showing them their portfolio back on March 9, 2009.
So what does this study mean?
It might be a bit extreme to go out and deliberately damage your brain to enable it to act more rationally. And I'm thinking some ethical issues would come into play if I gave my clients a drug to lower the activity in their amygdala.
So with the above two options off the table, I suggest we just accept that, as humans, we are programmed to act irrationally. Understanding this is the first step in being a more rational investor.
I suggest a cognitive approach that uses logic to overcome our emotions, irrespective of which part of our brain is generating any specific instinct.
Remember, it's actually better to buy when markets are lower than after a five year run-up. And though it appears that I'm stating the obvious, because I am, you should also remember that it goes against every chemical reaction in our brain.
One of the study's authors, Benedetto de Martino, a Caltech visiting researcher from University College London, noted in one of the comments:
subjects were not asked to play hypothetical gambles but they actually played real gambles and in many cases they also lost some money in the experiment as a consequence of their decisions
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