Battle of the Binge

Are impulsive money moves wrecking your returns? Here's how to keep yourself in check.

By Bob Frick, Senior Editor

From Kiplinger's Personal Finance magazine, November 2005

Fear and Loathing

Now what do you do if you reach into that fourth nest and a snake bites you? You'll almost certainly start giving nests a wide berth. When a pattern is broken, your brain generates feelings of fear and revulsion -- which is a good thing because it lessens the likelihood of future snake bites. But that is not necessarily a desirable outcome for investors. If a company releases a poor earnings report, you may sell the stock even if it is still a sensible investment, or you may be so disgusted that you do nothing when, in fact, you should sell the stock.

Because our minds are wired to avoid the unpleasant, bad memories last much longer than good ones. Stanford's Knutson, a professor of psychology and neuroscience, says that positive stimulation is short-lived. "Those mechanisms turn on and off quickly," he says. "But if you're scared by a saber-toothed tiger, you'll be scanning the bushes for the next three years."

Trusting patterns is one thing. But what about trusting people? Science has something to say on that subject, too. The "trust game" has become a staple of neuroeconomic research. Variations exist, but basically the game involves a trustee and an investor. The investor sends the trustee money, and the rules of the game say that that mere act automatically expands the amount of cash. The trustee may then share the wealth with the investor and return some of the money or -- and here's the rub -- the trustee may burn the investor and send back nothing.

You might think that behavior in such a game would be based on a simple financial calculation: "I'll send more money if I get more back." But Paul Zak, an economist at Claremont Graduate University, in Claremont, Cal., says trust is an emotional response. A hormone called oxytocin fills different areas of the brain in social situations, such as bonding between spouses or between parents and children. "We are a social species, and it's a good thing that we can learn how to trust," he says. As the trust game shows, a certain amount of cooperation between parties benefits both of them.

Just how powerful is oxytocin? In a version of the trust game, Zak and other researchers discovered that simply squirting a dose of oxytocin up a test subject's nose prompted the person to give the trustee more money.

Beating Mr. Hyde

Although neuroeconomics identifies the reasons for our actions, it's less helpful in prescribing corrective measures. But that doesn't mean you have to wait a few hundred thousand more years for your brain to evolve to the point that you can approach your finances more rationally.

The overarching rule is that investors must learn to recognize situations that will set off emotional decisions. "Then you can place yourself in a circumstance that doesn't require you to make snap decisions," says Grafman, the NIH scientist. When it comes to trust, for example, you shouldn't act on someone's financial advice just because you like the person. "If your tennis partner tells you about a stock, stop and think about it," says Claremont economist Zak.

If you are presented with a high-reward opportunity -- say, a broker calls with a hot tip on a penny stock -- wait. Acting on impulse means you won't properly weigh the risks involved. Let your Dr. Jekyll spend some time researching the stock -- no sense in having a highly evolved brain if you don't use it. And be aware of patterns. Sometimes they're valid, sometimes they're not. Get the big picture about a company before investing.

Follow these other simple rules, and you stand a much better chance of moving the investment decision-making process into the rational part of your brain:

Don't fixate on the short term. A daily, or even hourly, diet of news fires up Mr. Hyde and can trigger fear and greed, two emotions that often trip up investors (see box at left). In the same vein, don't check the prices of your investments too often.

Set long-term goals for your investments. Research has shown that as soon as you stop thinking short term and start thinking about the long term, the emotional part of your brain shuts off.

Diversify and examine the performance of your portfolio as a whole. Big rewards and big losses set off emotional responses. A diversified portfolio evens out these ups and downs.

Set a timetable for when to sell stocks, mutual funds and other investments. That "sell discipline" creates rational goals and preempts emotional reactions.

Throw Mr. Hyde an occasional bone. If you crave excitement, place a bit of your portfolio in a separate account and use that money to speculate on penny stocks, pork bellies or whatever else satisfies your dark side.

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