Check Your Head

From the June 2005 issue of Psychological Science comes this fascinating insight - to be truly successful in the markets, you have to check your head at the door. 

Download InvestmentEmotion.pdf

In an article entitled "Investment Behavior and the Negative Side of Emotion" the researchers asked the question whether dysfunction in neural systems lead to better investment decisions?

The researchers investigated how "normal participants," (defined as people with normal emotional responses) made investment decisions versus patients with emotional dysfunction (those with focal lesions in specific components of a neural circuitry that includes the amygdala, orbitofrontal, and insular/somatosensory cortex, which have been shown to be critical for the processing of emotions)

The answer: "emotionally dysfunctional" patients made more advantageous decisions and ultimately earned more money from their investments than the "normal participants".

When normal participants either won or lost money on an investment round, they adopted a conservative strategy and became more reluctant to invest on the subsequent round.  This is despite the fact that participants in each round had a 50%-50% chance of winning (a coin flip).  These results suggest that they were more affected than dysfunctional patients by the outcomes of decisions made in the previous rounds.  Essentially, the emotionally dysfunctional patients won more money and showed better understanding of odds than the normal participants.

Some edited exerts from the study -

Most people display extreme levels of risk aversion toward gambles that involve some risk of loss, if the gambles are presented one-at-a-time, a condition known as “myopic loss aversion” (11). For example, most people will not voluntarily accept a 50- 50 chance to gain $200 or lose $150, despite the gamble’s high expected return. Myopic loss aversion has been advanced as an explanation for the large number of individuals who prefer to invest in bonds, even though stocks have historically provided a much higher rate of return – a pattern that economists refer to as the “equity premium puzzle."

Normals were more likely to withdraw from risk-taking both when they lost on the previous round and when they won. Compared to the target patients (emotionally dysfunctional) who invested in 85.2% of rounds following losses on previous rounds, normal participants invested in only 46.9% of rounds.

Similarly, compared to target patients (emotionally dysfunctional) who invested in 84% of rounds following wins on previous rounds, normal participants invested in only 61.4% of rounds.  These results suggest that normal participants were likely to avoid risk (be more conservative)
regardless of winning or loosing in the previous round.

Further, the results suggest that normal participants were considerably less risk aversive following wins than following losses (normals: 61.4% vs. 46.9%, a difference of 14.9%) compared to target patients (85.2% vs. 84%, a difference of only 1.2%).

These results support our hypothesis that patients with lesions in specific components of a neural circuitry critical for the processing of emotions would make more advantageous decisions than normal subjects when faced with the types of positive expected value gambles that most people routinely shun.

Most theoretical models of risk-taking assume that risky decision-making is largely a cognitive process of integrating the desirability of different possible outcomes with their probabilities. However, recent treatments have argued that emotions, and particularly feelings of fear, play a central role in decision-making under risk. The finding that lack of emotional reactions may lead to more advantageous decisions in certain situations lends further support to such accounts.

Our results raise several issues related to the role of emotions in risky decision making.
It is apparent that neural systems that subserve human emotions have evolved for survival purposes. The automatic emotions triggered by a given situation help the normal decision-making process by narrowing down the options for action, by either discarding those that are dangerous or endorsing those that are advantageous. Emotions serve an adaptive role speeding up the decision-making process. However, there are circumstances in which a naturally occurring emotional response must be inhibited, so that a reflected, deliberate and potentially “wiser” decision can be made. 

The current study demonstrates this “dark side” of emotions in decision-making. On the basis of these results, we suggest that moods and emotions can play useful as well as disruptive roles in the process of making advantageous decisions, depending on the circumstances.

Comments

[Heraclitus]

Nice post. The game was however rigged so that taking lots of risk paid off, both in terms of expected profit and likely expected terminal utility The symmetric study to this would be to examine participants' behaviour in selling insurance/short option type payoffs.

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