Brain Neurons: The Backseat Financial Drivers
Written and accurate as at: Apr 18, 2024 Current Stats & Facts
Whether choosing a mortgage plan, saving for retirement or creating a daily budget, our daily decisions impact our financial future. However, even when we think we’re making rational decisions, neuroscience and psychology studies suggest otherwise. An intricate dance exists between our brains and financial behaviours you may be unaware of.
The Brain Behind the Bucks
Neuroscientists and economists are at the forefront of financial decision-making research, delving into why we often veer from rationality. Studies using neuroimaging technology such as fMRI scans point to two key areas of the brain—the ventral striatum and the anterior insula. These brain regions are heavily involved when we assess risk and reward. The ventral striatum is linked to reward anticipation, helping us decide when to invest in high-risk assets, whereas the anterior insula plays a role in risk aversion, often discouraging us from taking a risky bet.
Our brain’s processes aim to help us; for example, heuristics use mental shortcuts to facilitate efficient problem-solving and quicker judgment. These systems use generalisations to reduce cognitive load but if left unquestioned, can lead to inaccurate or irrational conclusions.
Common Financial Biases
Research also sheds light on common biases that influence our financial decisions. Many of these are related to the disposition effect which leads investors selling assets that have increased in value while still holding onto declining assets.
- Herding: People often mimic the financial behaviours of the majority, such as buying stocks when everyone else is buying and selling when others are selling. This bias is driven by social instinct and neural circuits related to social conformity.
- Loss Aversion: According to neuroscience, the pain of losing money is psychologically twice as painful as the pleasure of gaining the same amount. This can lead investors to avoid necessary risks or to hold onto stocks for too long.
- Recency Bias: This bias occurs when investors focus on recent events more than earlier events. For example, if the stock market has recently dipped, investors may panic and sell off assets even if the broader market trends suggest growth over time.
- Anchoring: In financial decision-making, individuals may rely too heavily on the initial information or benchmark they receive. For example, they may subconsciously hold onto the purchase price and let this influence future decision-making processes. Even highly educated corporate managers are not immune to cognitive biases. Studies suggest that personal history and overconfidence can significantly affect financial decisions, leading to less optimal outcomes like misguided mergers or poor investment strategies.
- Educate: Boost your financial literacy to understand and navigate the complexities of financial products.
- Biases: Be aware of how biases can cloud your financial judgments and strive to counteract them.
- Technology: Use financial planning tools and apps to maintain discipline in your financial life.
- Consult: Sometimes, a fresh, informed perspective can make a big difference in making sound financial choices.
As neuroscience unravels the complexities of our brain’s role in financial decision-making, it becomes clear that a complex array of neural activities and cognitive biases influences our financial behaviours. By understanding these processes and employing strategies to increase self-awareness and self-control, we can make better, more informed financial decisions that align with our long-term goals.