Losing hurts and sometimes a lot.
Earning $ 100 can make many people happy, but losing $ 100 can provoke an emotion even more intense than that joy.
That example is given to BBC Mundo by Arman Eshraghi, Professor of Finance and Investments at the University of Cardiff, to explain that magnetic resonance imaging of the brain has shown that “losses trigger greater activity in areas of the brain associated with negative emotions than those that generate (equivalent) earnings in pleasure centers”.
Although in the past, the medical field was the one that mainly focused on the study of the brain, in recent decades, other fields, such as finance, have also sought to understand it.
Economics has been merged with neuroscience to give an explanation to our behaviors, either as investors or as consumers, taking into account not only the brain but also the nervous system and even hormones.
What is known as neurofinance has emerged, “a relatively new area that strives to understand financial decision-making by adding insights from psychology and neuroscience to traditional theories of finance,” says Kerstin Preuschoff, associate professor of finance. Neurofinance and Neuroeconomics of the University of Geneva.
This neural understanding is especially important in “environments of risk and uncertainty , in which we generally react first and then analyze,” Joselyn Quintero, a financial advisor specializing in Financial Psychology and Neurofinance, tells BBC Mundo.
So what clues does that field give us about the way we make money decisions?
The emotional charge
Try as we might, our nature keeps us from straying from the fact that every choice we make has an emotional element to it.
“This is the case for all kinds of decisions and it applies particularly to financial ones. With investment decisions specifically, there is the hidden promise of wealth that has a strong emotional element, ”says Professor Eshraghi.
“Even the most experienced financial managers can make decisions that are not based solely on rational thinking.”
Despite the fact that for more than 30 years, experts in behavioral finance have successfully used the knowledge of psychology, sociology and even physics to try to elucidate how we decide, “advances in technology have allowed neuroscientists to map the chemical and electrical processes that occur in our brain when we make decisions ”.
Going back to the $100 example, specialists had already identified this pattern called loss aversion , but “neurofinance has allowed us to see what is really going on in the brain.”
How can we make better financial decisions?
Eshraghi believes that “the best financial decisions are often made using slow, careful and analytical ‘thinking’ rather than quick and inductive ‘feeling’.”
Obviously emotions cannot be removed from the equation, but part of the key is to be aware of them.
For example, “when financial markets are volatile , it is usually better to ‘ stay out ‘ and stop staring at screens.”
The reason is that the “wiring” of our brains reacts to unstable contexts in a more emotional than analytical way.
There is a phenomenon that occurs among some investors and it is what psychologists call “anchoring”: the tendency to stick to random numbers.
“Even the seemingly innocuous information can reach our subconscious. For example, investors can anchor themselves to the existing price levels of a stock and when new news hits the market, some are slow to react and update what they think.
Other people become attached to brands and companies that are familiar to them and, when investing or buying, “that can lead to a lack of diversification and eventually it is not a solid financial strategy.”
We are more than logic
Daniel Kahneman is the author of the book Thinking, Fast and Slow and argues that our mind has two systems of thought that influence the way we make decisions.
While System I deals with the intuitive, instinctive and unconscious, System II deals with the analytical, the conscious, the logical.
Although he is an influential psychologist, Kahneman received the Nobel Prize in economics in 2002 for his pioneering work, along with Amos Tversky, on the irrational element in decision-making.
In fact, both were the first to identify loss aversion.
Kahneman challenged the stream of traditional economic thought that we are rational, logical, and selfish when it comes to choosing, and thereby laid the foundation for behavioral economics.
Advice from a Nobel
“Why we make bad decisions about money (and what we can do to respect)” (Why We Make Bad Decisions About Money (And What We Can Do About It) it is the title of a video on the website Big Think, which Kahneman shed some lights:
“For certain types of decisions, you need the ability to compute numbers . People who own it have a significant advantage over those who don’t.”
“Understanding compound interest makes a huge difference, whether you borrow with a credit card or have savings.”
And, according to the expert, “people have a very confusing idea of compound interest and that is very harmful.”
It also talks about the importance of taking a broad perspective on what is happening and avoiding overly strong emotional reactions to events.
Consider that you win a little and lose a little and that your emotional response to small gains and small losses is very limited. That tends to induce better decision making”.
Seek guidance
The article Daniel Kahneman: Four Keys to Better Decision Making , published on the CFA Institute website , states that “we tend to overestimate our chances of success, especially in the planning phase.”.
When something does not go well, we look for an explanation, “you have the feeling that you have learned something and that you will not make that mistake again,” says Kahneman, but perhaps a cause-effect relationship is not the best conclusion of what happened.
“What you should learn is that you were surprised again. You must learn that the world is more uncertain than you think ”.
Another aspect that the Nobel recommends avoiding is regret , as it is “the greatest enemy of decision-making in personal finances.”
It also invites you to cultivate curiosity and seek a guide. The best advisor is “a person who likes you and who doesn’t care about your feelings .”
If you find it, it is very likely that it will give you good advice.
And when you are about to make an important decision: go slowly.
The importance of the margin of error
Being flexible and adapting to new circumstances is also key when making money-related decisions.
Morgan Housel is the author of The Phychology of Money and discusses how important it is to open up to mistakes.
“Too much devotion to a goal, a path, a result, is to invoke repentance when you are so susceptible to change,” he wrote in a blog that bears the same title as his book.
“People underestimate the need for margin of error in almost everything they do that involves money.”
According to the expert, it is due to “the idea that their vision of the future is correct, driven by the uncomfortable feeling that comes from admitting otherwise.”
But that causes them “economic damage” because it prevents them from taking the best actions.
Housel also argues that the margin of error is misinterpreted, “it is often seen as a conservative protection, used by those who do not want to take much risk or do not trust their views.”
“But when used properly it is the opposite. The margin of error allows you to hold on and that resistance makes you stay long enough so that the chance of benefiting from a low probability result falls in your favor. ”
And, in many cases, making a profit is also a matter of time.
“I’ve found that when making money decisions, it helps to constantly remember that the purpose of investing is to maximize returns, not to minimize boredom. Boring is perfectly fine. Boring is good . If you want to frame this as a strategy, remember: opportunity lives where others are not and others tend to stay away from boring”.
What millionaires do
William Leith is a journalist and author of The Trick: Why Some People Can Make Money and Other People Can’t .
His research led him to delve into the world of some millionaires.
“The people I interviewed, who got rich in some way, had developed an understanding of what risk was and how often it is counterintuitive.”
“That is essential,” he tells BBC Mundo. But there is something else: they went through various failures, learned from them, changed, and moved on.
“And each time they get a little closer to how things work” until they become “the few who are successful.”
“The reason is that almost everyone would give up much sooner because they fail and fail and fail. Most people can’t take it. ”
“It’s about doing things that most would not do (…) or that everyone thinks will not work or are risky.”
It is to see the risk from a “real” perspective and not from what “your heart tells you, but what your head tells you “.
Leith highlights an element that Kahneman had anticipated for us: curiosity.
“If you want to start a business, you have to see what is happening and what is changing. You have to find out for yourself “, because the books will show you” the world that existed yesterday, so you have to go out and start.”
Think for yourself: How can I improve this? This is how people succeed,”how he stands out from the crowd.
How to react
Quintero, the financial advisor, highlights the successful experiences that have occurred in the middle of the pandemic.
Entrepreneurs who have seized opportunities in the midst of very difficult circumstances because, as Leith points out, they stopped to observe what is happening.
“When you ask a financier, ‘In the midst of all this, what would you do?’ He is going to talk to you about cutting expenses. Its tendency is to minimize risks as far as possible, “he says.
“What we have become is people who are not only risk-averse, but also obsessive with certainty. In other words, we don’t move if we don’t have something to guarantee that things will work out”.
“That means that when you are presented with a situation that you have no way to control, the tendency is to withdraw, to close.”
And, many times, that prevents us from seeing the opportunities that exist.
The expert explains that industrial thinking seeks certainty, is based on security and reacts to the short term .
“If I want to have more income, then I should work longer hours. We parallel the costs with the benefits. To earn more I have to work more ”.
But the digital age is imposing another paradigm in which there is a greater understanding of the long term and sustainability.
The new paradigm
In this new paradigm, says Quintero, an element comes into play: self-esteem.
“Knowing that although you are going to do something that is not necessarily going to be liked by many people, the certainty is you, the only guarantee you have, instead of seeking certainty (outside), is you.”
As you gain mental clarity on an idea or a project, the results will emerge and a validation process will begin.
“When you talk to a person who is 25, 27 years old, his probability of generating money is clearer than a person of my generation , who was born 40, 50 years ago, that is, the possibility of earning more spending less time is now a generational narrative and, therefore, naturally you focus and move around that ”.
“When the baby boomer generation is exposed to this type of thinking, they have the idea that these people do not want to work or that they want to earn everything without doing anything, when in reality the issue is not so much what they do, but where they do it from ”.
The expert reflects on how many baby boomers felt that they had to work at something they did not want to make money, which contrasts with the mindset of millennials and centennials :
“I do what I like because I earn money doing it. From there I set up a business model that serves society, but which is fundamentally part of me”.
A complementary approach
The traditional financial system has been based on a regulatory scheme: on how things should be and not on how they are, says Quintero.
Neurofinance presents a complementary approach:
“Instead of telling a person what to do, I begin to understand what he is doing” and, in this way, an action plan is created that “is more like that individual – that includes their aspirations, desires – and not that he frames it in a pre-established formula ”.
And in that context, there are several factors that explain why there are people who have a harder time making good financial decisions.
Some are “paralyzed” because they are super-prepared and others because they think, for example, that since “they did not study at university, that makes them feel less intelligent”, when intelligence “is actually the ability to learn from what is happening, adjust yourself and get better”.
“Analysis paralysis”, he explains, is often experienced by highly analytical people: “I am missing the latest report, the most recent graph, the latest update. It is as if they were hijacked in his analytical mind. ”
And many times when that happens, the person disconnects from what is most important to them and sets their goals ” based on those of others.”
Even making some kind of profit, it may not make much sense because it is anchored in something external, not in its own, he explains.
While in traditional finance the maximization of returns is sought: “I must earn as much as I can”, in neurofinance there is talk of satisfactory returns.
In the middle
Quintero, like many experts, consider that we must avoid extremes: we win or lose and approach it as a process in which we improve our capabilities.
“For example, if I consider that my returns this year should be 7% per month. In a month I can reach 10%, but in another 5%. If I consider that a learning opportunity, instead of a failure, the next time I invest, save or buy, I am going with an apprenticeship and not a failure on top ”.
One question, according to the expert, is valid: How do I feel?
“Experience, from a neuroscience point of view, is a coding in the central nervous system that allows us to learn from our own reactions.”
“If I realize that I have a tendency to be more impulsive in certain scenarios, I begin to observe that behavior and identify what are the variables that trigger it and thus create a strategy.”
Some more than others
For the specialist, one of the key aspects to understand why some people find it easier to make money than others is the way uncertainty is assumed and handled.
“Risk is a key element in the financial world, it belongs to an analytical area. The risk allows us to do some calculations to maximize the results. The uncertainty is more connected with the emotional part. ”
And in the way we react to it, personal, family and cultural elements come into play.
“There are people for whom the word opportunity generates a feeling of guilt and although there are ethical and legal opportunities, they are not going to move because there is a cultural element that slows them down.”
Two people in the same environment can respond differently to the same event:
“One has an empowering narrative in which risk and uncertainty are associated with adventure and are physically and biologically arranged to enter it.”
“And you have another that links them to danger, like a threat, from which you have to protect yourself. Both his body and his biochemistry are preparing to avoid it and to flee”.
Like everything in life, it is about a balance and although there is no exact formula for how to make money – since each success story has its peculiarities – a balance between many internal and external factors is essential.