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A new investing tool – MRI brain scans

Richard Loth

Much of investment theory is based on the notion that investors act rationally and consider all available information in their investment decision-making. However, in recent years, researchers have uncovered a surprisingly large amount of evidence that this often is not the case.Respected academic experts such as Robert Shiller, Richard Thaler, Daniel Kahneman, and Meir Statman, to name a few, as well as prominent money managers like David Dreman and Ken Fisher, have written extensively on investors’ irrational behavior.A field known as “behavioral finance” has evolved that attempts to better understand and explain how emotions and cognitive errors influence investment decisions. Many researchers believe the study of psychology and other social sciences can shed considerable light on investment results. One of the more fascinating of these behavioral finance studies was reported on by Justin Fox in Fortune magazine in March. He reported that Princeton University psychology professors Sam McClure and Jonathan Cohen used brain scans to “watch the flow of blood” between the different parts of the brain when people decide between current and future rewards, and related their findings to individual investors.The conclusion of the study shows that the “higher brain isn’t able to stir us to action without the lower brain’s help.” When it comes to investing, this means that the latter panders to our immediate desires while the former prompts us to make more appropriate longer-term choices. Thus, individuals aren’t necessarily incompetent but rather conflicted when electing to spend and consume rather than save and invest.If you go to the Investor Home Psychology Web site (www. investorhome.com/psych) you’ll find an abundance of interesting commentary and references on the relationship of emotions and investing. The following selected remarks have been excerpted from this material:• “People are overconfident in their own abilities. Investors frequently trade on information they believe to be superior to that of others. On one side of each trade is a participant who believes he or she has superior information and on the other side is another participant who believes his/her information is superior. Yet they can’t both be right.” • “Investors typically give too much weight to recent experience and extrapolate recent trends that are at odds with long-run averages and statistical odds.”• “Benjamin Graham [“The Intelligent Investor”] believed that the market frequently mispriced stocks. This mispricing was most often caused by human emotions of fear and greed. At the height of optimism, greed moved stocks beyond their intrinsic value, creating an overpriced market. At other times, fear moved prices below intrinsic value, creating an undervalued market.”• “There is a large body of evidence documenting the fact that historically, investors mistakenly overestimate the prospects of growth companies and underestimate value companies. Research suggests that value strategies yield higher returns because these strategies exploit the mistakes of the typical investor and not because these strategies are fundamentally riskier.” Tough decisionsIn my Nov. 17 column I wrote about the serious defects of defined-contribution plans – such as 401(k)s – as retirement funding vehicles. The key problem here is the self-directed nature of these plans – the participants are expected to make their own investment decisions. The record shows that most are doing a poor job of investing their retirement money.The above mentioned Princeton University behavioral finance study offers an explanation why this so. While perfectly designed in most aspects, 401(k)s “turn out to confound the human brain more than help it. The chief problem seems to be that the decisions associated with them are just too hard for many people.” Unfortunately, the same may often be said for a large majority of the general investing public.The Investing Wisely column is written by Richard Loth, managing principal of Mentor Investing and an independent registered investment adviser. Loth can be reached at 328-5591 or mentor@centurytel.net.Vail, Colorado


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