Drugs, Sex and Stocks: How Your Brain Works When You Trade
May 2004: Brian Knutson, a professor of neuroscience and psychology at Stanford University, made a breakthrough in trading psychology. Knutson found that the mind of a trader lusting for money is identical to that of a person lusting for sex.
It is no secret that there are libraries worth of research on the impact traders' decisions have both on their individual portfolios and the broader market. Researchers attempting to overcome these results-oriented findings are delving into the human mind to figure out why traders are making decisions.
Even the most respected traders can make poor decisions. These decisions can be attributed to both incorrect mindsets and to emotions overcoming reason. An example of bad mindset is illustrated in the work published by highly regarded economist John Keynes called General Theory of Employment, Interest and Money. Keynes compared predicting successful stocks to predicting the winner of a beauty contest.
How would you decide? Keynes argued that the majority of people would pick the girl they perceived to be the prettiest; the truth is that it is less important to consider who you think is the prettiest girl is and more important to determine the girl everyone else perceives to be the most beautiful.
Many top investors are fixated on the fact that logic and reason prevail when it comes to successful investing. Brian Knutson's experiments found that the occupation which is best approached objectively is actually an extremely emotionally charged experience. Knutson put volunteers under an fMRI (a device which produces a dynamic image of the human mind) and when these volunteers participated in a trading simulator the results were dope.
By dope, I mean pure dopamine. Every three out of four trades the volunteers made was considered wise and rational, however, every fourth trade revealed really poor judgment. These bad judgment calls came in the form of greed, holding a stock that has just jumped to try to squeeze out as much profit as possible or pure foolishness, investing in a stock which has already proven unreliable. The reason for these bad calls appeared to be a war going on in the minds of the traders.
When someone traders, there is literally a battle going on between the Nucleus Accumbens (brain pleasure center) and the Anterior Insula (the part of the brain connected to negative emotional experience). Peoples' minds constantly in flux; the pleasure part of the mind seeks profit with the same vigor as a drug addict seeking a high, while the cautious part of the mind attempts to prevent loss by avoiding all risky plays.
Volunteers with more active Anterior Insulas were 20% less likely to invest in stocks that burned them in the past while the volunteers with more active Nucleus Accumbens were less hesitant to jump into profitable situations.
So, now that we have gained insight into the brain psychology of trading what can you do? The truth is: not much. Psychoactive drugs that affect our brain processes are still products of science fiction, but there is an important action any trader can take before making a move. Next time you are about to make a trade stop, think about why you are about to make the trade, and recognize the war going on in your mind. Even if you can't change the chemical makeup of your brain you can control which impulses you act upon.
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