Finance, and the Anatomy of The Human Brain

Does it guide us to make common investment mistakes?

By Gregory J. McLaughlin, MS, CFP®

The fundamental investment principle that we all tell clients early on is “buy low and sell high”. We all know it’s true, so why is it that so many investors all too often do the opposite? To start, we might be able to blame the human brain.

The human brain is one of the most powerful organs, in that has the ability to direct and manage our responses to a variety of stress triggers – in particular, emotional triggers. With the economic volatility we have seen over the past few years, many individuals are experiencing emotional stress in their daily lives due to market swings, job security – not to mention the constant media coverage of today’s environment.

Some investors are able to rationally deal with investment volatility and recognize that market cycles are normal in the course of a financial plan. For others who are already living with existing stress from their job, family or physical tensions; additional stress brought on by market fluctuations can only exacerbate fears, anxiety and turmoil that their financial goals may be more difficult to achieve. Many of the emotional and physical feelings we have from stress are actually set in motion by the brain; and once we understand the part that our brains play in an investment strategy, we can help manage these emotional responses.

The area of the brain that deals with our emotions is called the limbic system. It is a highly evolved system that not only affects our emotions, but also our behavior, perceptions and memories. As we grow older and are exposed to more stressful experiences, our limbic system keeps note of these experiences and uses them to form “fight or flight” responses to new stress. This is why you see many investors panic or have systemic anxiety because their brains are taking note of market swings and perceiving them as threats to their physical and emotional well-being. The result for some investors is that they can become so fearful of large swings in the market, that they are afraid to stay the course – and ultimately may make dangerous decisions that could cost them more financial harm in terms of tax penalties, loss of savings for the future or the missed opportunities for recovery when the markets ultimately come back.

There are investors out there who are improperly diversified based on their risk tolerance, time frame or economic situation. In those cases, we cannot simply blame their human anatomy. At the same time, there are investors who are very well diversified, both in investment classes, diversification of financial products and their overall time frame. Yet, many of these investors have emotional swings and panic based on significant market changes.

Here is one example:

A client had come to our firm a few years ago during the market swings of 2009 and was looking for guidance on what to do with this retirement portfolio. He stated that the pressure of the markets had become too much to bear, so he moved his 401(k) assets into cash. At first, we thought, okay, well you may want to re-diversify your assets from just the cash and money markets fund classes in your 401(k) to something more balanced during this time of volatility.

He stated, “no…what I mean is, I actually did not move the assets into a cash or money market class in my 401(k)…I actually pulled out of my 401(k) altogether and put the money into my bank.” This gentleman was in his early 50s. This was before we had met him, and that decision set in motion tax penalties of 10% for removing assets from his qualified plan before age 59 ½, as well as income taxes.

Not to mention the fact that he was completely out of the market in his 401(k) [his most significant asset in his portfolio] for when the market returns occurred later in that year. Because he took receipt of that money personally and it was not rolled into a new qualified plan within the required 60 day period for rollovers, there was no way around his tax penalties. In this case, the only option he had was to work to re-build his investment strategy and help better educate and counsel him on the role of market cycles and at least him get back to a more proficient strategy.

Unfortunately for him, he was not receiving guidance from qualified professionals at that time and his “fight or flight” responses took over due to the physical and emotional anxieties he was feeling. Part of the role of a financial advisor is to be an emotional guide through market challenges and help change old memory anchors into educated understanding.

The way we can help to work through anchors and biases is to focus on the progress towards our goals as a measure of success. Focus on doing a proper, comprehensive financial analysis towards future goals, so that you are less likely to anchor on one specific piece of information. This helps you clearly focus on the bigger picture.

A well-balanced financial portfolio should encompass your general investments, qualified retirement plans, as well as your disability income protection, life insurance protection and long-term care insurance protection. Insurance components, within a comprehensive portfolio, can help investors understand that they have personal income protection in times of crisis and can help shelter their investments later in life by protecting their ability to earn an income now, or help protect their retirement assets during times of extended long-term care.

Once the overall plan is complete, often times it is helpful to break down a client’s overall investment portfolio into different “buckets” of money that will be needed at different stages of their life, particularly during retirement. While the bucket approach is by no means a new concept, it is found to be extremely helpful in stressful or volatile times in our economy. Since we are all human it is obviously impossible to completely eliminate emotions, however by making decisions based upon time frame and intentions, the appropriate solutions are easier to identify during good and bad times in the economy.

The initial comprehensive financial profile that is conducted with a financial professional is tremendously important and has enduring impact. Most individuals have a bias toward the present, and procrastination becomes one way of dealing with anxiety. If a client has their assets wrapped within a comprehensive financial program, you can show investors how they have a means of personal security during times of economic downturns.

Excessive media coverage of a particular topic will always keep that issue at the forefront of one’s brain, and we need to be sensitive to this with greater outreach to our clients. There is also the risk of overestimating the probability of an event because it is associated with a previous memory. We’re all human and we all make mistakes. It helps to realize that a systematic investment and insurance program with regular reviews helps people focus on overall financial goals and can help them not get too worried about what is likely going to be blips in the future. The human brain functions to help guide our actions and emotions, but sometimes you need a long-term vision to keep you anchored on your goals.

All investing involves risk, including the risk of loss of principle. Diversification and asset allocation do not guarantee a profit or protect against loss. Past performance is not an indication of future results.