Knowing about behavioral finance has shed a lot of light to understand investors. During the last few years, scientists have focused on a field that investigates the financial behavior of people. The theory is called behavioral finance, or behavioral finance.

The collaboration between important sources of knowledge, such as psychology, neurology, and economics, has developed two emerging disciplines: 1) neuroeconomics (applied to the general field) and 2) microfinance.

Neuro finance deals with the study of the impact that psychology has on investment and financial decisions, as well as its consequences on the markets.

Until a few years ago, investment experts and technicians argued that markets behaved efficiently and, therefore, predictably.

However, the contributions of behavioral finance have revealed how markets become inefficient as a result of irrational movements, caused by the emotional decisions of buyers and sellers.

Support for behavioral neuroeconomics and finance has been strong as a result of the extensive work done by Daniel Kahneman (cognitive psychologist) and his collaborator Amos Nathan Tversky (mathematical psychologist).

Daniel was awarded the Nobel Prize in Economics in 2002. His work is reflected in the book ” Thinking: Fast and Slow “, delving into two brain systems that influence economic decision-making.

It is the first time in history that a psychologist has won a Nobel Prize in Economics, which can give us an idea of ​​the enormous importance that emotions and psychology can have on the results of our investments.

Behavioral finance helps detect where irrational movements in the markets can occur, due to emotional factors that trigger greed, fear, anxiety, and other emotions in investors: the news, the recommendations of “experts”, certain economic data of a company or a sector, political and social events of great magnitude, etc.

Behavioral finance helps non-professional investors to avoid making mistakes, which are the ones that lead the general public to make disastrous decisions for their economy, guided by the “herd effect”.

This effect can be observed in nature with large flocks of birds, or fish, which are capable of sudden and rapid movements in the same direction. One of the benefits of belonging to a group, which also occurs in humans, is the reduction of stress: the person feels safer and more comfortable when their behavior is supported by all members of the group.

The “herd effect” is the cause that when a movement to sell shares or stock market values ​​begins, there is a common understanding that there is a threat of a drop in prices.

Non-professional investors, not wanting to lose their money, are quick to divest their stocks, even profitable ones, further causing the downtrend. Professional investors, aware of this effect, can – indeed do – manipulate the markets, with many inexperienced investors cleverly taking their money.

What causes the “herd effect”? In the animal world, a shot from hunters or the appearance of a predator triggers an internal mechanism (related to the reptilian brain or primitive survival center) and causes many useless deaths due to the route.

In the case of people, the impulse is similar, it can be the fear of losing money or the desire for a quick profit, which is reinforced by the massive behavior of investors, who act emotionally, not rationally, when faced with certain stimuli.

KNOW THE PHYSIOLOGICAL BASE OF YOUR FINANCIAL BEHAVIOR

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Behavior towards money, finances, and investments is based on how people’s brains have evolved over thousands of years.

Thanks to technological advances such as the scanner, it has been possible to measure the response of certain areas of the brain to emotions that intervene in investment activity. Let’s look at the three parts of your brain and what needs it is related to.

Table of Contents

The primitive or reptilian brain

It is the most primitive and its development is calculated about 500 million years ago. It is found mainly in reptiles (hence its name). Its basic function is to contribute to survival, with three possible responses to a vital threat: attack, flee, or immobilization.

His response is instinctive, emotions have no influence. This part of the brain does not think, does not feel, and does not reason. It is in the present, totally connected to the action. It is related to the basic needs to survive, that is, to obtain food, to perpetuate the species through sexual activity, and to protect against threats from the environment.

This part of the brain controls the automatic functions of the body: breathing, heart rate, the locomotor system, the digestive system, and the states of wakefulness and sleep.

It is responsible for uncontrolled physiological responses. It registers the subconscious part of people, who act impulsively and without thinking as an automatic response to a real or imagined threat.

The investor’s fear of losing money resides in the primitive or reptilian brain. Through tests such as the electroencephalogram, the measurement of heart rate, blood pressure, sweating hands, or dry mouth, the physiological intensity has been measured and the painful impact of loss is twice as high. then the satisfaction obtained from the profit.

A picture is worth a thousand words. I give you a very visual example. Imagine that someone invites you to approach a glass box, with a highly venomous rattlesnake inside. The box is completely transparent and has a lid that isolates the snake from the outside.

You reach out your hand, curious. The snake responds to your closeness with a very quick movement toward your hand. Without thinking for a split second, you jump back and walk away from the box. What happened? Your primitive brain doesn’t reason, it doesn’t have time to make you think that the snake can’t hurt you; Your body releases adrenaline, propelling you into an extremely fast withdrawal movement and protecting you from possible deadly damage.

This reptilian brain is always present in your economic and investment decisions. The conservation instinct drives the investor to purchase shares without considering, even if the price is higher and higher, compromising the profitability of their money.

This situation is similar to animal behavior when faced with hunting prey, which disputes with other animals to guarantee its food and that of its litter.

This primitive brain is behind the quick decisions of people who, in a panic, part with some values ​​that the market is penalizing in their price due to some news or event.

Do you remember the brutal fall of the stock markets in the world when the candidate of the Republican party, Donald Trump, seemed that he was going to win -against all the odds- against the favorite candidate, of the Democratic party, Hillary Clinton?

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After the results in favor of Trump were consolidated, the movement of the Stock Markets was a real roller coaster, since after millions in losses in the main values ​​of the world markets there was a spectacular rise in prices. How much money did investors lose on that day?

Who took advantage of the change in trend and obtained huge capital gains? How is it possible to go from a general stock market pessimism to the most unpredictable optimism? Neuro-finance has the answer.

The limbic or emotional brain

The limbic or emotional brain is related to emotions and is activated both in the possible reward for gains, and the loss aversion. It develops through learning or repetition of behaviors. The search for what we like, or pleasure, is taken into account in all current advertising and marketing science. Do you know the continuous campaigns carried out by a company, Coca-Cola, with its messages of “the spark of life” that associates the consumption of this drink with happiness?

” Neuromarketing is a discipline whose function is to investigate and study brain processes that make the behavior and decision-making of people in the fields of action of traditional marketing clear (market intelligence, product, and service design, communications). , prices, positioning, channels, and sales). Wikipedia source.

In terms of savings, finance, and investment, this emotional characteristic of the human brain is used especially in product advice, where aspects that people like are highlighted, leaving them calm and arousing positive emotions. Neuroeconomics “studies economic behavior to better understand brain function , and studies the brain to examine and complement theoretical models of economic behavior.”

The impact of emotions on economic decisions is very important. Money losses are related to non-rational impulses and desires. First, the decision is made impulsively and then it is rationalized. Here are some examples:

Entering a pyramid business with the illusion of quick profits and under the emotional pressure of someone close.

Lending money to a family member without considering the viability of the business that you propose and your ability to repay.

Starting to invest in the stock market without having sufficient preparation, because the neighbor or a friend has told you that money is earned.

Hire a complex investment product offered by the director of the financial institution where you have your account, because he tells you that they only offer it to the best clients and that it is a good opportunity.

Signing a mortgage loan contract without reading the conditions, because you feel that the employees of the bank office “behave well with you and are not going to deceive you”.

Hire a “revolving” or deferred payment credit card, even though it has high-interest rates because they tell you that the monthly fee to pay is very small.

Buy cryptocurrencies paying attention only to the fact that it is a product that is going to have a great future, without paying attention to whether the price is high or low.

Buy weekly lottery tickets, thinking that it can also be your turn and that your life can change by magic.

Situations in which you can make economic decisions coated with the emotion of earning a lot of money, quickly and effortlessly, will present themselves to you throughout your life. It doesn’t matter if you ever go to the casino and leave some money in the slot machines. Assume that this money -previously- is lost. Who has not had the illusion that luck, this time, is on our side?

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Rational brain or neocortex

In the neocortex resides the logical system of thought, analysis, and decision-making. Biologically it is the most modern and evolved, it is in charge of shedding light on the different data and impressions that come to us from the environment.

The French philosopher, mathematician, and physicist, Rene Descartes, with his studies on thought and consciousness in people, marked a decisive stage in the way of contemplating the human being. With his famous statement, “I think, therefore I am”, he defended thought as a fact that distinguishes us from animals, driving analysis, and data management, unlike the non-conscious impulsive response of beings lacking superior intelligence.

This approach to the value of thought has had a great impact from the 17th century to the present. It has been an eminent neuroscientist and neurologist of Portuguese origin, Antonio Damásio, who has made great contributions to science, emphasizing that human beings are, as well as rational, very emotional. His book “Descartes’ error” reveals how people make very fast decisions, unconsciously and with an emotional basis. Those emotions not only reside in the brain, but are present in every cell and the nervous, endocrine, and circulatory systems.

Recognizing the impact of emotions in people’s lives has meant a closeness to their diverse and changing reality.

Let us now see what are the functions of the neocortex or rational brain:

  • Receives and analyzes data, draws conclusions, makes decisions
  •  Compare data, discard information
  • Assign values ​​to that data, prioritizing, giving them value
  •  Organizes the information received
  •  Can go from the concrete to the abstract and without obvious meaning
  •  Establishes relationships between data to draw new conclusions
  • Able to be creative and inventive
  • Anticipates results based on previous data
  • It is capable of inhibiting actions or postponing them
  • Analyze and manage time

If you think and are aware of it, you make a difference between your thinking being and the being that is aware that it is thinking. You become an observer.

You can be aware of the thoughts that come to your mind from everything that is happening around you, and at the same time, you can be aware of thoughts arising in yourself.

One of the biggest problems people have is “identification” with their feelings and thoughts. “I am impulsive”, “I am passionate” or “I am careless” reflect behavior, which can be changed. For a person to make significant changes in himself, he has to become aware of his conditioned behavior patterns, which come a little from genetics, a lot from his personality, and the education received in his family environment.

In the world of money, finances, and investments, emotionality, typical of the reptilian brain and the limbic brain, does not provide much efficiency, quite the opposite. Proof of this is the emotional biases that are detected time and time again in economic decision-making, with inefficient results, loss of accounts, businesses that fail due to a lack of realistic planning, and stock market investments that would not have been made if they had not been taken into account. account objective data.