I came across an article in the Journal of Financial Planning that really opened my eyes to how our brain works in terms of making financial decisions. The title is Money on Your Mind: The Brain’s Role in Financial Decision-Making.
Now you’re probably thinking, it sounds like a pretty wonky publication, but It's really not. If you’re at all interested in the role emotional intelligence plays in your relationship with money and investing, you have to read this case study. If the memory of the DJIA dropping over 900 points in one day is still a vivid memory, this is a must read.
*Tip-As you read the story, play the observer role. Observe what you’re feeling and note any physical sensations to the various events such as increased heart rate or shortness of breath. It’s these emotional triggers that cause our brain to go from rational to Stone Age before you can say Fred Flintstone.
A Case Study
John Sanders woke up in a sweat after a restless night tossing and turning. It was the morning of October 10, 2008, one day after the Dow Jones Industrial Average tumbled nearly 680 points. It was one of the largest single-day point losses ever, wiping out hundreds of billions of dollars in market value. The credit markets were frozen and the United States House of Representatives had created a crisis of confidence by voting down a $700 billion bank bailout plan.
John and his wife Susi were in their mid-50s and hoping to retire in about five years. The previous night before dinner, John had gone on Morningstar’s Web site to survey the damage to their retirement accounts. Looking at a sea of ugly red arrows, John felt his heart pounding. His hands were shaking. He could barely sit still on his home office desk chair. Susi called him for dinner, but there was no chance he could swallow even a bite. “We can’t afford to lose any more money than we already have this month,” John decided. He clicked over to his retirement funds company, and transferred all his equity mutual funds into his linked money market account.
During the next few days the market rebounded. On October 13, the market rose 936 points—the largest single point gain in history—closing at 9,389.61. Driven by excitement, John made another quick decision, and bought back in to the funds he had abandoned only three days earlier, thereby locking in nearly $100,000 in equity losses. The market rebound was short-lived, and by March 9, 2009, the DJIA had fallen to 6,547.05, down more than 25 percent from the beginning of that year. If John had either stayed in the market and never sold or stayed out of the market once he sold, his investment value would have been higher than it was by March 9, 2009.
He reacted to the stock market dive as if it were a matter of life or death. He made several quick decisions driven by fear and greed. If a car had been about to crash through his home office wall on October 9, 2009, John’s quick reflexes could have saved the day. But as unpleasant as the decline in the stock market was, it wasn’t an emergency. In fact, the U.S. markets were, as always, closed for the night, and nothing more awful was going to happen before they reopened the following morning. John had plenty of time to think through what he should do about the sorry state of the stock market. And since he and Susi weren’t planning to retire for at least five years, nothing in their current life was in jeopardy because of the stock market’s performance during the previous days and weeks. But none of that reasoning made it into John’s thought process, because John, like all of us, was hampered by a Stone Age brain. John’s brain, like ours and our clients’, is well-equipped to handle physical survival, but pitifully unprepared to deal with the challenges of today’s complex financial environment.
Your Stone Age Brain
In the last 30 years or so, new technologies have revolutionized the way we live our lives. High-tech tools have profoundly affected the way we interact with money: We get cash from the ATM, make purchases with credit cards, pay our bills online, and check the latest stock prices on our smartphones. But all this technological sophistication is masking two dangers. One, technology makes it easier for us to spend money impulsively. Money is available 24/7. Credit cards let us buy things even if we can’t really afford them. Easy access to money, coupled with a culture that prizes material possessions, has created an epidemic of thoughtless and often catastrophic overspending across all socioeconomic groups.
Another danger is that our current social climate of continuous technological advances creates the illusion that we humans are more advanced and sophisticated than we really are. It’s true that Homo sapiens are great at making new tools. But when it comes to decision-making, we’re relying on an old-model brain. Our brains were optimized to handle the challenges of life 10,000 years ago. Our brains are still evolving, but they can’t begin to keep pace with the societal, cultural, and economic changes of the last 100 centuries, let alone the last 100 years.
While the brain inside your head is only as old as you are, its structure and circuitry date back to prehistoric times. Scientists who study human evolution say that the human brain, which grew and changed dramatically over the course of millions of years, has not significantly changed in size, weight, or organization in the last 50,000 years. From that, we can suppose that our brains were ideally suited to dealing with the demands of the environment at least 50,000 years ago. If we knew what life was like for people who lived that long ago, we could understand what kinds of situations our brains are equipped to handle. Unfortunately, we don’t really know anything about people’s lives that far back in time. But, thanks to the work of archeologists and paleontologists, we do have a picture of what humans faced 10 to 20 thousand years ago.
Around 10,000 BCE, humans were hunter-gatherers, that is, they found food either by hunting for wild animals or by gathering edible plants and flowers. It took about another thousand years or so for humans to figure out how to grow food by cultivating land and planting seeds. (And it took another 10,000 years to come up with supermarkets and Starbucks!) Humans who lived 10,000 years ago developed specialized stone tools (hence the term “Stone Age”) to help them build shelters and acquire food. They lived in small groups, often in dwellings constructed of stone and roofed with animal skins. They moved around a lot, most likely to find fresh sources of food. Stone Age humans’ major challenges happened in the physical world: How to avoid getting eaten by a woolly mammoth, how to figure out whether a plant was edible, or how to protect their families from the elements or from unfriendly tribes out to steal their supplies. Their brains were wired to help our species survive, not make complicated investment decisions. As Richard Peterson, noted psychiatrist, hedge fund manager, and author of Inside the Investor’s Brain: The Power of Mind Over Money, explains:
If you’re a tribesman in the Serengeti region of Tanzania, Africa, and you come across a mango tree, you want to get as many mangoes off that tree as you can before a lion shows up. In that scenario, greed and fear are good. Those emotions are essential to survival. Really extreme emotions keep you alive. The trouble is, when it comes to financial matters, there’s nothing like the mango tree. The stock market isn’t a mango tree full of mangoes. It’s a completely different and unpredictable entity. But we deal with it as though it was that mango tree.
While our neural programming is brilliantly organized to help us meet physical challenges, it’s not built to handle contemporary challenges such as financial decision-making.
Excerpted from the Journal of Financial Planning, April 2010, Volume 23: Money on Your Mind: The Brain’s Role in Financial Decision Making by Doug Lennick, CFP with Kathy Jordan, Ph.D.