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HOT TOPIC: Sum of All Fears

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Sum of All Fears: Are Risk Aversion and Greed All in the Mind?

When the market takes a dive, are you more likely to change course or stay the course? What about when the market is rising? Are you more likely to follow the crowd and buy more, or do you maintain your investing strategy?

If the answer to the first question is "change course" and the answer to the second is "follow the crowd and buy more," you could be letting your emotions drive your behavior. Emotional reactions can cause investors to buy high during the exciting phase of a market bubble and to sell low during a downturn when panic sets in, exactly the opposite strategy of what rational investors are supposed to do.

Although the ability to analyze situations quickly and make on-the-spot, emotion-based decisions was necessary to survive and thrive in cave-man days, it generally is not appropriate when investing in the stock market.

Fear of loss and anticipation of gains are strong human emotions that have been studied not only by behavioral finance researchers but also by neuroscientists. Now independent research studies suggest that two areas of the brain — one that controls fear and another that seeks reward — may be behind emotional investor behavior.

Fear Factor
In one study of why some people turn down gambles that are likely to lead to gains, researchers at the California Institute of Technology and their colleagues examined the reactions of patients who had a genetic condition that damaged a structure of the brain known as the amygdala, the brain's "fear center," compared with the reactions of a control group without amygdala damage. In a series of monetary gambles in which the participants had different possibilities of losing or gaining money — equal probabilities of winning $20 or losing $5 (which is a risk many people would take) or winning $20 or losing $20 (a risk many people would reject) — the patients with damage to the amygdala invariably chose the riskier option. In fact, the participants with amygdala damage demonstrated no aversion to monetary loss, which contrasted with the more cautious control group. Researchers concluded that "a fully functioning amygdala appears to make us more cautious."1

Although loss aversion has been observed in many economic studies, "this is the first clear(scientific) evidence of a special brain structure that is responsible for fear of such losses."2

Pleasure and Greed
At the other end of the spectrum, a team of Japanese researchers found that greed is influenced by an area of the brain called the striatum, which is described as a "major reward-related brain structure." Winning a financial reward increased activity in this area, but so did the simple possibility of monetary gain. The higher the risk, the greater the amount of activity in the striatum.3

A Quantitative Difference
Does this mean that emotion has no place in prudent investment decision making? Although a healthy sense of fear and a drive to succeed are necessary for sound decision making, these emotions may not always guide investors in the right direction and could end up in losses over the long run compared with a more disciplined approach.

Nature has hard-wired us for survival, but relying too much on our natural impulses can end up causing monetary harm. You may be able to avoid some common mistakes and help achieve your goals by basing your financial decisions on a sound investment strategy that takes into consideration your time horizon, risk tolerance, and personal circumstances.

1) Reuters, February 8, 2009
2) PhysOrg.com, February 8, 2010
3) Science Daily, November 19, 2009

The information in this article is not intended as tax or legal advice, and it may not be relied on for the purpose of avoiding any federal tax penalties. You are encouraged to seek tax or legal advice from an independent professional advisor. The content is derived from sources believed to be accurate. Neither the information presented nor any opinion expressed constitutes a solicitation for the purchase or sale of any security. This material was written and prepared by Emerald. © 2010 Emerald.

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