Your Money and Your Brain

1. Neuroeconomics: Your Brain on Money

To get the best use out of any tool or machine, it helps to know at least a little about how it works; you will never maximize your wealth unless you can optimize your mind.

Mind over Money. Neuroeconomics reveals that our financial decisions are not purely rational but are deeply influenced by our brain's emotional and instinctive responses. Understanding this interplay is crucial for making better investment choices.

• The brain's reward system, designed for survival, reacts to potential financial gains similarly to food or sex.
• Emotional circuits, developed over millions of years, often override our logical reasoning when it comes to money.
• By understanding the biological basis of our financial behavior, we can learn to manage our impulses and make more informed decisions.

The Investing Brain. The investing brain is not a consistent, logical device but a complex system of neurons that generate powerful emotions when we think about money. This system combines cold calculations about probabilities with instinctive reactions to the thrill of gain and the anguish of loss.

• Even Nobel Prize winners struggle to apply their own economic theories to their personal portfolios.
• Financial decisions are not just about money but also about intangible motives like avoiding regret or achieving pride.
• The investing brain is at its best and worst when making decisions about money, highlighting the need to understand its complexities.

Harnessing Emotions. Emotion is not the enemy of good financial decisions; pure rationality without feelings can be just as bad for your portfolio as unchecked emotion. Neuroeconomics shows that the best results come from harnessing emotions, not strangling them.

• People with head injuries that prevent them from engaging their emotional circuitry can be terrible investors.
• The key is to strike the right balance between emotion and reason, using both to your advantage.
• By understanding our investing selves better, we can set realistic objectives, earn higher returns, and become calmer, more patient investors.

2. The Tug-of-War: Thinking vs. Feeling

Often, the more convinced you are that your hunch will pay off big, the more money you are likely to lose.

Two Brains, One Investor. Our investing brain is a battleground between two systems: the reflexive (intuitive) and the reflective (analytical). The reflexive system, driven by emotion and instinct, reacts quickly and automatically, while the reflective system, based in the prefrontal cortex, is slower, more deliberate, and analytical.

• The reflexive system is fast, automatic, and often unconscious, while the reflective system is slow, deliberate, and conscious.
• Most financial decisions are a tug-of-war between these two ways of thinking, and the challenge is to get them to work better together.
• Intuition has a role to play in investing, but it should be subordinate to analysis, not dominant.

The Reflexive Brain. The reflexive brain, located in the basal ganglia and limbic areas, is designed to seek rewards and avoid risks as quickly as possible. It is highly sensitive to change and novelty, often leading to impulsive decisions.

• The reflexive system works so fast that you often finish responding before the conscious part of your brain realizes there was anything to respond to.
• It is designed to focus attention on stimuli most likely to be of importance, often ignoring what remains constant.
• This system can lead investors to overreact to short-term market fluctuations and chase hot stocks or funds.

The Reflective Brain. The reflective brain, located in the prefrontal cortex, is responsible for complex problem-solving, planning, and evaluating advice. It can intervene when the reflexive brain encounters situations it cannot solve by itself.

• The reflective system can intervene when the reflexive brain encounters situations it cannot solve by itself.
• It is limited by the power of your memory and the complexity of what you are measuring.
• People who rely blindly on their reflective systems often end up losing the forest for the trees, overanalyzing data and missing the big picture.

3. Greed: The Thrill of the Chase

Anticipating a financial gain puts the reflexive part of your investing brain on red alert, focusing your attention keenly on the task at hand.

Anticipation vs. Satiation. The anticipation of making money often feels better than actually making it. This is because the brain's reward system is more aroused by the possibility of a gain than by the gain itself.

• The nucleus accumbens, a key part of the reward network, fires more intensely when anticipating a reward than when receiving it.
• This "seeking system" is designed to motivate us to pursue longer-term rewards, but it can also lead to a compulsive craving for the big score.
• The thrill of anticipation can be so powerful that it can lead investors to chase risky ventures that offer the hope, but never the reality, of high returns.

The Seeking System. The seeking system, a fundamental part of our brain, is designed to make us want to do what our ancestors had to do: pursue rewards and avoid risks. This system is activated by the possibility of a gain, focusing our attention keenly on the task at hand.

• The seeking system is a two-stage process: first, looking backward with memory, and second, looking forward with hope.
• It is more sensitive to the size of a potential reward than to the probability of receiving it, leading us to chase long shots.
• The anticipation of anticipation of reward can also trigger an impulsive rush, making us crave the feeling of expecting a gain.

Controlling Greed. To keep the seeking system from leading to financial trouble, it's important to recognize that it will get carried away. You must impose checks and balances to avoid chasing every hot return.

• Be wary of anyone who tries to lure you with jackpot jargon like "double your money" or "the sky's the limit."
• Limit the amount you put at risk on speculative trading, and never add more money to a speculative account.
• Control your cues by cleaning up your environment and exposing yourself to fewer triggers that can goad you into trading.

4. Prediction: The Illusion of Control

The newest findings in neuroeconomics suggest that much of what we've been told about investing is wrong.

The Futility of Forecasting. The human brain is wired to seek patterns, even in random data, leading us to believe we can predict the unpredictable. This "prediction addiction" drives us to rely on market strategists and financial analysts, despite their poor track records.

• The market is usually right, and the collective intelligence of millions of investors has already set a price for whatever you're trading.
• It takes money to move money, and brokerage costs and taxes can erode profitable ideas.
• Randomness rules, and no matter how carefully you research an investment, it can go down for reasons you never anticipated.

The Pattern-Seeking Brain. Our brains are designed to detect and interpret simple patterns, a skill that helped our ancestors survive. However, this ability can lead us astray in the complex and often random world of financial markets.

• Humans are uniquely obsessive about seeking patterns, even where none exist.
• We tend to base our predictions of long-term trends on surprisingly short-term samples of data.
• The left hemisphere of the brain drives us to search for patterns and to see causal relationships, even when none exist.

Dopamine and Prediction. Dopamine, a chemical in the brain, helps us figure out how to take actions that will result in rewards at the right time. It is triggered not by the reward itself, but by the cue that predicts it.

• Getting what you expected produces no dopamine kick, while an unexpected gain fires up the brain.
• If a reward you expected fails to materialize, then dopamine dries up, creating a motivational vacuum.
• The release of dopamine can be triggered by a stimulus that has made you money before, leading to a compulsive craving for the big score.

5. Confidence: The Danger of "Knowing"

The single biggest step you can take to improve your investing results is to stare long and honestly into a mirror to see whether you really are the investor you think you are.

The Overconfidence Bias. One of the most fundamental characteristics of human nature is to think we're better than we really are. This overconfidence can lead to poor investment decisions and a failure to learn from our mistakes.

• Most people believe they are above-average drivers, investors, and decision-makers.
• Overconfidence can be useful in some areas of life, but it can be dangerous in the financial markets.
• The less skilled or experienced you are at something, the harder your inner con man works at convincing you that you are brilliant at it.

Home Bias and the Illusion of Control. Overconfidence often leads to a "home bias," where we put too much trust in whatever is familiar, such as the company we work for or the region we live in. It also creates an "illusion of control," where we overstate how much power we wield over our own circumstances.

• People tend to invest too much money in the stock of the firm they work at, believing they know more about it than other companies.
• The illusion of control causes us to become complacent, to put too little effort into planning ahead, and to be overcome by surprise when our investments tank.
• We often tell ourselves that we foresaw what was going to happen, even if, in the past, we had no idea what the future would hold.

The Limits of Knowledge. We have a terrible time admitting when we don't know something, and the more we know, the more we think we know even more than we do. We're even overconfident about our ability to overcome our own overconfidence.

• The single greatest challenge you face as an investor is handling the truth about yourself.
• It's vital to recognize the basic realities of pattern recognition in your investing brain: it leaps to conclusions, is unconscious, automatic, and uncontrollable.
• By understanding the limits of our own knowledge, we can make better decisions and avoid the pitfalls of overconfidence.

6. Risk: More Than Just Numbers

The possibility of loss makes the hope of gain even more tantalizing.

Subjective Risk. Our perception of risk is not fixed but is in constant flux, depending on our memories, emotions, and the context of the situation. What seems risky to one person may seem perfectly safe to another.

• How much risk you take is supposed to depend on how much risk you can stomach, but this is often a lie.
• Our perception of risk is influenced by our mood, our past experiences, and whether we are alone or part of a group.
• The slightest change in context or description can turn you from a raging bull to a cowardly bear in a matter of seconds.

The Power of Framing. How a risk is described, or "framed," can have a significant impact on how we perceive it. A risk framed as a potential loss will often be perceived as more dangerous than the same risk framed as a potential gain.

• People can derive more "relative pleasure" from a gamble that offers the chance either to win or lose money than they do from a gamble that offers only upside.
• The possibility of loss makes the hope of gain even more tantalizing, as our brains are designed to pay closer attention to rewards when they come surrounded by risks.
• Marketers and financial professionals often use framing to manipulate our perceptions of risk and reward.

Controlling Risk. To manage risk effectively, it's important to focus on what you can control, such as your expectations, your risk, your readiness, your expenses, your commissions, your taxes, and your own behavior.

• Be on your guard against anyone who tries to lure you with jackpot jargon like "double your money" or "the sky's the limit."
• Limit the amount you put at risk on speculative trading, and never add more money to a speculative account.
• Control your cues by cleaning up your environment and exposing yourself to fewer triggers that can goad you into trading.

7. Fear: The Amygdala's Alarm

Financial losses are processed in the same areas of the brain that respond to mortal danger.

The Amygdala's Role. The amygdala, a key part of the brain's fear circuitry, acts as an alarm system, generating hot, fast emotions like fear and anger when we confront a potential risk. This system is designed to protect us from danger, but it can also lead to overreactions in the financial markets.

• The amygdala can flood your body with fear signals before you are consciously aware of being afraid.
• It is highly sensitive to change, novelty, and anything that seems scary, often leading to impulsive decisions.
• The amygdala is also sensitive to social signals that transmit an alarm, such as a television broadcast from the floor of the stock exchange on a bad trading day.

The Impact of Fear. The fear of financial loss can be as powerful as the fear of physical danger, triggering a cascade of physiological responses that can impair our judgment.

• The expectation of financial losses can switch on the amygdala, making us more risk-averse.
• A single drop in the stock market can disrupt the investing behavior of millions of people for years to come.
• The memory of a financial loss can be burned into our brains, making us more cautious and less willing to take risks in the future.

Managing Fear. To manage fear effectively, it's important to recognize that it is a natural response, but it doesn't have to control your decisions. You can learn to control your fear by:

• Taking a time-out before making a hasty decision you might regret later.
• Using words to counteract the stream of images the markets throw at you.
• Tracking your feelings and learning to recognize when your emotions are running high.

8. Surprise: The Brain's "Oops" Moment

After two repetitions of a stimulus—like, say, a stock price that goes up one penny twice in a row—the human brain automatically, unconsciously, and uncontrollably expects a third repetition.

The Power of Surprise. The brain is exquisitely sensitive to the slightest difference between what we expect and what we get. This "surprise" response is a powerful way we learn from our experience.

• The anterior cingulate cortex (ACC) is a key area of the brain that helps generate the feeling of surprise when our normal expectations are shattered.
• The ACC is also involved in detecting errors and focusing attention, helping us adjust our behavior to get it right next time.
• The more often you are exposed to something, the less intensely your brain tends to respond to it, a process known as adaptation.

The Asymmetry of Surprise. The brain reacts more strongly to negative surprises than to positive ones. This is because the dopamine system is more interested in novel stimuli than familiar ones.

• Getting what you expected produces no dopamine kick, while an unexpected gain fires up the brain.
• If a reward you expected fails to materialize, then dopamine dries up, creating a motivational vacuum.
• The release of dopamine can be triggered by a stimulus that has made you money before, leading to a compulsive craving for the big score.

Managing Surprise. To minimize the impact of surprise on your investing decisions, it's important to:

• Realize that the financial markets are inherently unpredictable and that surprises are inevitable.
• Focus on what you can control, such as your expectations, your risk, and your expenses.
• Stop predicting and start restricting, using strategies like dollar-cost averaging to prevent yourself from making too many bets.

9. Regret: The Pain of What Might Have Been

Investing requires you to make decisions using data from the past and hunches in the present about risks and rewards you will harvest in the future—filling you with feelings like hope, greed, cockiness, surprise, fear, panic, regret, and happiness.

The Nature of Regret. Regret is a powerful emotion that arises when we compare what did happen to what might have been. It is often triggered by our own actions, especially when we could have chosen other options.

• Regret is likely to be hotter, sharper, and more painful when the outcome appears to have been caused directly by your own actions.
• It is also more intense when you came close to your goal, making a "near-miss," or when your mistake was the result of what you did rather than what you did not do.
• The anticipation of regret can be a powerful motivator, but it can also lead to paralysis and inaction.

The Endowment Effect and Loss Aversion. Once we own something, we tend to value it more highly than we did before we owned it. This "endowment effect" makes us reluctant to sell losing investments, even when it would be the most rational thing to do.

• We are more sensitive to losses than to gains, a phenomenon known as "loss aversion."
• This makes us more likely to hold on to losing investments, hoping they will eventually recover, and to sell winning investments too soon, fearing they will lose their gains.
• The fear of regret can lead to portfolio paralysis, where we are afraid to take any action that might make things worse.

Managing Regret. To manage regret effectively, it's important to:

• Face it and fess up, talking about your mistakes with someone you trust.
• Have rules for ruling things out, preventing yourself from making too many bets.
• Get help pulling the trigger, seeking a second opinion before making a decision.
• Seek the silver lining when you sell, focusing on the tax benefits and the opportunity to invest in something better.

10. Happiness: The Real ROI

Anticipating a gain, and actually receiving it, are expressed in entirely different ways in the brain, helping to explain why "money does not buy happiness."

The Limits of Money. While money can improve our quality of life, especially when we are poor, it does not guarantee happiness. Once we have enough to meet our basic needs, more money buys much less extra happiness than we think it will.

• The pleasure we anticipate feeling if we win the money would change enormously if we multiplied or divided the amount of the jackpot by 10 or 100 or 1000, but your reaction to similar changes in probability would trigger very little emotion.
• The anticipation of making money often feels better than actually making it, as the brain's reward system is more aroused by the possibility of a gain than by the gain itself.
• The more we focus on money as an end in itself, the less happy we are likely to be.

The Power of Connection. How satisfied you are with your life depends, above all else, on how connected you feel to other people. Social connections, not material possessions, are the key to lasting happiness.

• Happier people have more friends and spend less time alone.
• They also tend to have stronger immune systems, lower levels of stress hormones, and a greater ability to recover from setbacks.
• By focusing on relationships and experiences, rather than just accumulating wealth, we can create a more fulfilling life.

The Path to Happiness. To get the most happiness out of your money, it's important to:

• Take a deep breath and create a few minutes of quiet time for yourself each day.
• Turn off the TV and other distractions that can make you feel envious or inadequate.
• Thrive while you drive by carpooling with friends and turning a negative experience into a positive.
• Go with the flow by engaging in activities that absorb your attention and make time seem to stop.
• Surprise someone with an unexpected gift, and you will both feel happier.
• Go back to school and learn something new, expanding your horizons and making new friends.
• Don't let the old become too bold, and protect yourself from scams and schemes.
• Accentuate the positive, focusing on what you have rather than what you lack.
• Go for the goal, making your future goals as specific and vivid as possible.
• Get time on your side, focusing on the long-term benefits of your decisions.
• Bottle up the urge to splurge, and segregate your money to prevent impulsive spending.
• Make your own luck by being curious, observant, and open to new experiences.

Last updated: January 14, 2025