Emotions Negatively Affect Investment Decisions

September 15, 2005 (PLANSPONSOR.com) - Research from Stanford University, Carnegie Mellon University, and the University of Iowa suggests that emotions get in the way of making prudent financial decisions.

Researchers at these universities analyzed the investment decisions made by people with brain lesions that rendered them unable to feel emotions, according to a news report on Stanford University’s Web site.   The subjects’ IQ’s were normal as well as the parts of their brains responsible for logic and cognitive reasoning.   Also included in the study were participants with “normal” brain function and a control group with brain lesions that did not affect their emotional ability.

According to the report, participants were given $20 to play in a 20-round gambling game.   At each round the participant could choose to risk $1 on a coin toss.   If they won, they received $2.50 and if they lost, they gave up $1.   Financially speaking, it made more sense to play each round, just as it is more prudent for people to leave their money in the stock market over the long term, in spite of market fluctuations.

The 15 (out of 41) participants who had brain damage that affected emotions invested in 84% of the rounds and earned an average of $25.70.   The “normal” participants invested in 58% of the rounds and earned an average of $22.80.   The control group acted in the same way as the “normal” group.

What the researchers found, according to the report, was that fear drove the “normal” and control group to risk-avoidance behavior.   Most participants started the same, investing rather than withholding, but as the game went on, the “normal” and control participants grew more cautious.   They also reacted emotionally to the outcomes of previous rounds, according to Baba Shiv, an associate professor of marketing at the Stanford Graduate School of Business and co-author of the study.

Shiv likens this to the puzzling trend of investors to prefer bonds over stocks, though stocks over the long haul provide a greater rate of return.   Shiv points out that evidence shows that when the stock market declines, people tend to shift their long term savings, like retirement savings, into bonds.   “Investors are not behaving in their own best financial interest. Something is going on that can’t be explained logically,” Shiv said, according to the report.

Another co-author of the study, Antoine Bechara, called successful investors “functional psychopaths”, people who are better at controlling their emotions or do not feel emotions as intensely as others.  

Though emotions might hurt an individual as far as long term investing, Shiv qualifies their findings by saying that people who suffer a stroke or otherwise incur brain damage that affects the emotional side of the brain in general end up making social and financial decisions that are highly disadvantageous.   “True, the results of this study have serious implications for things like investing for retirement, something that is central to our lives,” said Shiv in the report. “At the same time, we want to qualify our findings, because by and large, if you look at most of the decisions we make in our lives, emotions are key to their success.”

The report of the study is  here .