We’ve written before about how your emotions can have a significant negative impact on
your financial well being. In our previous article titled “Bad Behavior Can Cost You
Plenty”, we discussed the new field of behavioral economics. (You can read this article
by visiting the “In The News” web page on our web site. See the link below.)
Understanding why we do what we do can help us make better financial decisions.
Now, in a new book titled Your Money and Your Brain (Simon and Schuster, 2007), by
Jason Zweig, a senior writer for Money Magazine, Mr. Zweig explains the new science of
neuroeconomics and how it can help us manage our finances more intelligently.
Neuroeconomics is a mixture of neuroscience, economics and psychology.
Neuroscience involves the scientific study of the nervous system. According to
Wikipedia, “Neuroscience is at the frontier of investigation of the brain and mind.”
Zweig explains the basics of neuroeconomics in layman terms. He explains the two basic
types of thinking that are characteristic of the two major parts of our brains called the
reflexive brain and the reflective brain.
The reflexive part of the brain reacts to various stimuli and often works so fast that you
will have finished responding to the stimuli before you even realize that there was
something to respond to. For example, when you are driving down the road and a car
turns dangerously close in front of you, the reflexive part of your brain causes you to
immediately swerve to avoid collision. You can think of the reflexive part of your brain as
the reactive part. When it notices something different, it instantaneously reacts as
necessary, without you having to consciously think about it. It‘s the part of the brain that
significantly affects your intuition and emotions.
So what does this have to do with your finances? The reflexive part of your brain
causes you to react without really thinking through what you have observed and what
the real implications are. If the market drops 300 points today, people will react to the
change and not consider that with the Dow Jones Industrial Average at over 12,000, a
300 point drop represents only a 2.5% decline.
The reflective part of the brain is used primarily for solving more complex problems.
These are problems that require more time to address and require more analysis. The
reflective brain takes over when the reflexive brain cannot address a particular situation,
such as how to diversify your portfolio.
Zweig points out, however, that you need to have a balance between both the reflexive
brain and the reflective brain. Zweig says that engineers are often poor investors:
“That may be because they are trained to calculate and measure every possible
variable. I’ve met engineers who spend two or three hours a day analyzing stocks. They
are often convinced they’ve discovered a unique statistical secret that will enable them
to beat the market.” Zweig goes on to explain that with the reflective brain dominating
their thinking, engineers tend to squelch their intuition, which would have told them that
the same data they are using is available to millions of other investors. Their “unique”
analysis is essentially commonplace and of little value.
Zweig’s book details the results of dozen of neuroeconomic studies that show how
people react in various situations. He then ties it all together in each chapter by giving
do’s and don’ts that you can follow to put the findings of the studies to practical use.
It’s a great book, chock full of fascinating illustrations of how our mind works and how it
can affect our finances. We’d highly recommend it to any serious investor who wants to
improve their portfolio returns.
We were not surprised to see that one way Zweig suggested to take the emotion out of
your investing and put it on auto-pilot, was to implement an asset-allocation approach
with periodic re-balancing – precisely the approach we use with our clients!
David C. Patterson, CFP® and Erin Patterson, CFP® are the owners of Patterson Advisors, LLC, a fee-
for-service-only financial advisory firm. Patterson Advisors, LLC is a Registered Investment Advisor,
registered with the State of Michigan, helping clients in Waterford, Clarkston and Royal Oak, Michigan
as well as other Oakland County, Michigan communities . Visit www.pattersonadvisorsllc.com for more
information or call 248-674-2108.
Published in the Oakland Insider, May, 2008
A Book for All Investors to Read
By David Patterson and Erin Preston (formerly Patterson)