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Baba Shiv: Emotions Can Negatively Impact Investment Decisions

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Baba Shiv: Emotions Can Negatively Impact Investment Decisions

Research shows that how we feel can be the key to our success.

Emotions can get in the way of making prudent financial decisions. Thus concludes a study by a Stanford marketing professor that found that people with certain kinds of brain injuries earned more money investing than a comparison group.

The study was conducted by a team of researchers from Stanford University, Carnegie Mellon University, and the University of Iowa, and analyzed the investment decisions made by people who were unable to feel emotions due to brain lesions. The subjects' IQs were normal, and the parts of their brains responsible for logic and cognitive reasoning were unaffected.

Participants were given $20 at the beginning of a 20-round gambling game. At the beginning of each round, the participants were asked if they wanted to risk $1 on a coin toss. Those that said no kept their money. Those that agreed to participate earned $2.50 if they won the coin toss, but had to give up their $1 if they lost. Everyone then proceeded to the next round, in which the same steps were repeated.

Although the participants could decline to take part in any or all of the rounds, it made the most sense — financially speaking — to play each time because the potential return was so much greater than the potential loss.

"From a logical standpoint, the right thing to do was to invest in every round," said Baba Shiv, rofessor of marketing at Stanford GSB and co-author of the study. "With a 50-50 chance of winning, the expected value of playing each round was $1.25, while the expected value of not playing was just $1."

Of the 41 participants in the study, 15 had suffered damage in the areas of the brain that affected emotions, and these were the people who took the most profitable approach to the game. They invested in 84 percent of the rounds, earning an average of $25.70. In contrast, normal participants invested in just 58 percent of the rounds, earning an average of $22.80. To make sure that the study was not merely analyzing the difference between normal people and those with generic brain damage, the researchers also included "control" patients — i.e., participants with brain lesions, but not in areas that are involved in emotion processing. The control patients behaved in a manner similar to normal participants.

Fear seemed to play a large role in risk-avoidance behavior of the normal participants. What was especially interesting, said Shiv, was that all the players started out in roughly the same place: investing $1 rather than withholding it. But over time, the normal participants (and control patients) grew more cautious, declining to play almost as often as agreeing to risk $1 on the coin toss. "And what we found out, through additional analysis, is that normal individuals were reacting emotionally to the outcome of the previous round," said Shiv. "If they lost money, they got scared and had the tendency to fall back and decline to play further."

This study is especially relevant because of a concept called the "equity premium puzzle" that has long bemused financial experts. The term refers to the large number of individuals who prefer to invest in bonds rather than stocks, even though stocks have historically provided a much higher rate of return. According to Shiv, there is widespread evidence that when the stock market starts to decline, people shift their retirement savings — that is, their long-term, not short-term, investments — from stocks to bonds. "Whereas all research suggests that, even after taking into account fluctuations in the market, overall people are better off investing in stocks in the long term," said Shiv. "Investors are not behaving in their own best financial interest. Something is going on that can't be explained logically."

One of the co-authors of the study, Antoine Bechara, an associate professor of neurology at the University of Iowa, has ventured the theory that successful investors in the stock market might plausibly be called "functional psychopaths." These individuals are either much better at controlling their emotions, or perhaps don't experience emotions with the same intensity as others do. "Many CEOs and many top lawyers might also share this trait," said Shiv. "Being less emotional can help you in certain situations."

This isn't to say that emotions are overall a bad thing, stressed Shiv. When people suffer a stroke or otherwise incur brain damage that affects the emotional side of the brain, it impacts their lives negatively in a number of significant ways: They typically lose their jobs and their friends, and they often experience bankruptcy. In general, they 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. "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."

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