When possibility is in the room, probability goes out the window

Humankind evolved to seek rewards and avoid risks but not to invest wisely.

Read the complete article: Your money and your brain
By Jason Zweig, Money Magazine senior writer/columnist

For most purposes in daily life, your brain is a superbly functioning machine, steering you away from danger while guiding you toward basic rewards like food, shelter and love. But that brilliant machine [your brain] can lead you astray when it comes to investing.


QUIZ

Is your brain wired for wealth?

In Year One, Weeds.com earns $ 2.50 per share. In Year Two, it earns $ 5 per share. In Year Three, it earns $ 10 per share. What is your best estimate of what Weeds.com will earn in Year Four? $20 $5 $15 or How on earth would I know?

We're beginning to get answers. Scientists in the emerging field of "neuroeconomics" - a hybrid of neuroscience, economics and psychology - are making stunning discoveries about how the brain evaluates rewards, sizes up risks and calculates probabilities.

With the wonders of imaging technology we can observe the precise neural circuitry that switches on and off in your brain when you invest. Those pictures make it clear that your investing brain often drives you to do things that make no logical sense - but make perfect emotional sense.

Your brain developed to improve our species' odds of survival. You, like every other human, are wired to crave what looks rewarding and shun what seems risky.

To counteract these impulses, your brain has only a thin veneer of modern, analytical circuits that are often no match for the power of the ancient parts of your mind. And when you win, lose or risk money, you stir up some profound emotions, including hope, surprise, regret and the two we'll examine here: greed and fear.

Understanding how those feelings - as a matter of biology - affect your decision-making will enable you to see as never before what makes you tick, and how you can improve, as an investor.

Greed: The thrill of the chase
Why is it so hard for most of us to learn that the old saying "Money doesn't buy happiness" is true? After all, we feel as if it should.

The answer lies in a cruel irony that has enormous implications for financial behavior: Our brains come equipped with a biological mechanism that is more aroused when we anticipate a profit than when we get one.

In Knutson's experiment, a display inside the fMRI machine showed me a sequence of shapes that each signaled a different amount of money: zero ($0), medium ($1) or large ($5). If the symbol was a circle, I could win the dollar amount displayed; if it was a square, I could lose the amount shown.

When Knutson measured the activity tracked by the scan, he found that the possibility of winning $5 set off twice as strong a signal in my brain as the chance at gaining $1 did.
Whenever I captured the reward, Knutson's scanner found that the neurons in my nucleus accumbens fired much less intensely than they had when I was hoping to get it. Our anticipation circuitry... acts as a "beacon of incentive" that enables us to pursue rewards that can be earned only with patience and commitment.

If we derived no pleasure from imagining riches down the road, we would grab only at those gains that loom immediately in front of us.

Thus our seeking system functions partly as a blessing and partly as a curse. We pay close attention to the possibility of coming rewards, but we also expect that the future will feel better than it does once it turns into the present.... Getting exactly what they wished for left investors with nothing to look forward to, "so they got out and the stock crashed."

Brian Knutson has found that while your reflexive brain is highly responsive to variations in the amount of reward at stake, it is much less sensitive to changes in the probability of receiving a reward...

When possibility is in the room, probability goes out the window.
It's no different when you buy a stock or a mutual fund: Your expectation of scoring a big gain elbows aside your ability to evaluate how likely you are to earn it. That means your brain will tend to get you into trouble whenever you're confronted with an opportunity to buy an investment with a hot - but probably unsustainable - return.

Fear: What are you afraid of?
Here are two questions that might, at first, seem silly.

1 Which is riskier: a nuclear reactor or sunlight?

2 Which animal is responsible for the greatest number of human deaths in the U.S.? a) Alligator b) Deer c) Snake d) Bear e) Shark

Now let's look at the answers. The worst nuclear accident in history occurred when the reactor at Chernobyl, Ukraine melted down in 1986. Early estimates were that tens of thousands of people might be killed by radiation poisoning. By 2006, however, fewer than 100 had died. Meanwhile, nearly 8,000 Americans are killed every year by skin cancer, commonly caused by overexposure to the sun.

In the typical year, deer are responsible for roughly 130 human fatalities - seven times more than alligators, bears, sharks and snakes combined. Deer, of course, don't attack. Instead, they step in front of cars, causing deadly collisions.

None of this means that nuclear radiation is good for you or that rattlesnakes are harmless. What it does mean is that we are often most afraid of the least likely dangers and frequently not worried enough about the risks that have the greatest chances of coming home to roost.

We're no different when it comes to money. Every investor's worst nightmare is a stock market collapse like the crash of 1929. According to a recent survey of 1,000 investors, there's a 51% chance that "in any given year, the U.S. stock market might drop by one-third."

In fact, the odds that U.S. stocks will lose a third of their value in a given year are around 2%. The real risk isn't that the market will melt down but that inflation will erode your savings. Yet only 31% of the people surveyed were worried that they might run out of money during their first 10 years of retirement.

If we were logical we would judge the odds of a risk by asking how often something bad has actually happened under similar circumstances. Instead, explains psychologist Daniel Kahneman, "we tend to judge the probability of an event by the ease with which we can call it to mind."

The more recently it occurred or the more vivid our memory of something like it in the past, the more "available" an event will be in our minds - and the more probable its recurrence will seem.

Fear: The hot button of the brain
Deep in the center of your brain, level with the top of your ears, lies a small, almond-shaped knob of tissue called the amygdala (ah-mig-dah-lah). When you confront a potential risk, this part of your reflexive brain acts as an alarm system - shooting signals up to the reflective brain like warning flares. (There are two amygdalas, one on each side of your brain.)

The result is that a moment of panic can wreak havoc on your investing strategy. Because the amygdala is so attuned to big changes, a sudden drop in the market tends to be more upsetting than a longer, slower decline, even if it's greater in total.

On Oct. 19, 1987, the U.S. stock market plunged 23% - a deeper one-day drop than the crash of '29. Big, sudden and inexplicable, the '87 crash was exactly the kind of event that sparks the amygdala.

The memory was hard to shake: In 1988, U.S. investors sold $15 billion more worth of shares in stock mutual funds than they bought, and their net purchases of stock funds didn't recover to pre-crash levels until 1991. One bad Monday disrupted the behavior of millions of people for years. There was something more at work here than merely investors' individual fears. Anyone who has ever been a teenager knows that peer pressure can make you do things as part of a group that you might never do on your own.

But do you make a conscious choice to conform or does the herd exert an automatic, almost magnetic, force?

People were recently asked to judge whether three-dimensional objects were the same or different. Sometimes the folks being tested made these choices in isolation. Other times they first saw the responses of four "peers" (who were, in fact, colluding with the researcher).
When people made their own choices, they were right 84% of the time. When the peer group all made the wrong choice, however, the individuals being tested chose correctly just 59% of the time.

Brain scans showed that when the subjects followed the peer group, activation in parts of their frontal cortex decreased, as if social pressure was somehow overpowering the reflective, or analytical, brain. When people did buck the consensus, brain scans found intense firing in the amygdala.

Neuroscientist Gregory Berns, who led the study, calls this flare-up a sign of "the emotional load associated with standing up for one's belief." Social isolation activates some of the same areas in the brain that are triggered by physical pain.

In short, you go along with the herd not because you want to but because it hurts not to. Being part of a large group of investors can make you feel safer when everything is going great. But once risk rears its ugly head, there's no safety in numbers.