Neuroeconomics

Practical Applications of Neuroeconomics and Behavioral Finance ©2011

Presented by: Stacia Eyerly HatfieldOct 15, 2011

What we’ll cover

• Behavioral Finance– Framing– Availability & Anchoring Heuristics– Optimism & Overconfidence– Risk and Greed

• Neuroeconomics– Neurolinguistic Programming– Somatic Markers– What is written– Case studies– Short term neural changes

• Other

The Bad News

Mere presence of a financial advisor causes cerebral computations to shut down when risky decisions need to be made

“…one effect of expert advice is to “offload” the calculation of expected utility from the individual’s brain”

Source: Engelmann JB, Capra CM, Noussair C, Berns GS (2009) Expert Financial Advice Neurobiologically “Offloads”Financial Decision-Making under Risk. PLoS ONE 4(3): e4957. doi:10.1371/journal.pone.0004957

Behavioral Finance

FramingAvailability/AnchoringOptimism/OverconfidenceRisk/Greed

Cycle of Emotions

Humans vs Econs

• Biases & Blunders• Anchoring• Availability• Representativeness• Optimism and

Overconfidence• Status Quo Biases• Framing

• Resisting Temptations• Mindless Choosing• Self Control Strategies• Mental Accounting• Follow the Herd• Collective Conservatism• Priming

Framing

• Importance of carefully presenting alternative options– Of 100 patients that have this operation, 90 alive

after 5 years

– Of 100 patients that have this operation, 10 are dead after 5 years

Source: Richard H. Thaler, Cass R. Sunstein Nudge, Improving Decisions about Health Wealth, and Happiness (Caravan Books, 2008)

Implement Framing

A. Are you wiling to lose as much as 20% of your portfolio

B. You’ll likely keep 80% of your portfolio

A. There’s a 77% probability of achieving your goals

B. There’s a 23% chance that you’ll run out of money

Source: Richard H. Thaler, Cass R. Sunstein Nudge, Improving Decisions about Health Wealth, and Happiness (Caravan Books, 2008)

Availability

• Information that’s recent/easiest to access in an individual's mind

• Post 9/11, most people more concerned about terrorism than skin cancer or fatal head injuries from helmet-less bike riding (yet far higher chance of death from latter two)

Source: Richard H. Thaler, Cass R. Sunstein Nudge, Improving Decisions about Health Wealth, and Happiness (Caravan Books, 2008)

Availability

Availability

Availability

Implement Availability

• Market volatility still painful…yet

• It’s imperative that advisor bring historical context each and every time they meet with clients

• Can do this with a quick walk through of a Capital Markets Outlook (5-6 pages, mostly images)

• Remind them of press motivation-selling ad space!

Anchoring

• First number that we hear/think about is the number we base all following data around.– Last 3 digits of your phone number– Add 200. Write it down.– What year did Attila the Hun ravage

Europe?

• Why mutual funds launch with $10NAV—seems cheap

Source: Richard H. Thaler, Cass R. Sunstein Nudge, Improving Decisions about Health Wealth, and Happiness (Caravan Books, 2008)

Implement Anchoring

• When reviewing with client, never start with their portfolio-always talk about greater capital markets first (the anchor), then go into client’s individual performance—starting with longest term number available.

Keeping up with the Jones’s

Optimism & Overconfidence

• People unrealistically optimistic– Divorce impossible on your

wedding day • (50% do)

– 90% of small business owners think they will succeed • (50% do)

• Investors expect that their own portfolios earn 1.5% more than everyone else's

Risk & Greed

• Aging investors willing to assume additional risk without being rewarded for the compensation usually associated with such risk.

• Diminished accuracy for value predictions• Compelling reason that all investors

should have some professional advice as they age

Cooper, Woo and Dunkelberg (1988) & Jason Zweig, Your Money & Your Brain (New York, Simon and Schuster, 2007)

Risk & Greed

• Another study showed that when memory is tested to recall situations of financial gain, both the anticipation of reward lights up as well as the long-term memory center.

• People get excited by re-living the experience of a stock that’s done well. AAPL?

Gregory R. Samanez-Larkin, Camelia M. Kuhnen, Daniel J. Yoo, and Brian Knutson, “Variability in Nucleus Accumbens Activity Mediates Age-Related Suboptimal Financial Risk Taking” The Journal of Neuroscience, January 27, 2010 , 30(4):1426 –1434

• Implication: Advisors need to work extra hard to take away the importance of a short term financial gain, and replace with stories of about damage done in pursuit of a quick gain.

Overcoming Risk and Greed

What is Neuroeconomics?

Neuroeconomics:Combines psychology, economics, and neuroscience to study how people make decisions. It looks at the role of the brain while individuals evaluate decisions and categorize risks and rewards.

Technology Used:•Functional Magnetic Resonance Imaging (fMRI)•PET scans•EEG & MEG

Tactical Neuro StrategiesNeurolinguistic ProgrammingSomatic MarkersWhat is WrittenCase StudiesShort Term Neural Changes

Neurolinguistic Programming

Most impactful word in the English language:BECAUSE

“Excuse me, I have 5 pages. May I use the Xerox machine?”

“…because I am in a rush?” “…because I have to

make copies?”

Robert B. Cialdini, PhD, Yes! 50 secrets from the science of persuasion(Great Britain, Profile Books Ltd 2007)

Implement NLP

Mr. Client: “I need you to fill out the monthly cash flow statement BECAUSE your financial plan, which we use to help you achieve your goals, starts with this completed document.”

Ms. Client: “Although the markets contain risk in that they can go up and down, there are other risks to consider—inflation and longevity risk. BECAUSE we need to generate enough returns to address these other risks, we can’t construct a portfolio entirely in fixed income.”

Implement NLP

Anytime a word is expressed by a financial advisor that a client or prospect does not understand, the next 2-3 sentences are largely unheard.

• Asset Allocation• Correlation• Diversification• Expected Tracking Error

BTW NLP

Somatic Markers

• Bookmark for the brain• Help ancient ancestors survive rough living

conditions• Today’s application: www.willitblend.com

Source: Martin Lindstrom, buyology, Truth and Lies About Why We Buy (Doubleday, 2008)

Why Somatic Markers

1. To distinguish themselves from other financial advisors during the prospecting period.

2. Get a client to commit to specific goals.3. Use it to demarcate significant changes down

the road.

Implement Somatic Markers

• Dramatic use of images—projector screen• Use of sound—play a meaningful song (Baby

Boomers connect with the Rolling Stones)• Unexpected location: hotel lobby by the fire,

conference room of a public library, donut shop during the early morning frying time

Source: Lindstrom

Somatic Markers

WARNING!

The Written Word

• Volunteer Project– Active Form vs.– Negative consent“…commitments that

are made actively have more staying power than those that are

made passively.”

Source: Cialdini, Yes!; Personality and Social Psychology Bulletin, Vol. 22, No. 2, 133-147 (1996)DOI: 10.1177/0146167296222003

Implement Written Word

• Provide yellow notepad (or firm stationary)• If a couple, both members participate in

activity

• Bring original version at every annual meeting(Great tool for clients demanding to go to all cash)

Source: Cialdini

Case Studies

• Error exposure training• Used with fire-fighters– Depicted incidents containing errors of

management with severe consequences in fire-fighting outcomes

– Same set of case studies, but incidents managed well, no consequence

Source: Wendy Joung, Beryl Hesketh, Andrew Neal Using "War Stories" to Train for Adaptive Performance: Is it Better to Learn from Error or Success? Applied Psychology VL: 55 NO: 2 PG: 282-302 YR: 2006 ON: 1464-0597 PN: 0269-994X University of Sydney, Australia; University of Queensland, Australia

• Build (mental) storybooks for your clients

Implement Case Studies

Case Studies: Caution

• Stories powerful tool to influence behavior• When given statistical evidence & anecdotal

story telling opposite side, individual far more swayed by story—suboptimal decisions made

• Be even handed when telling stories

Source: Wainberg, James, Kida, Thomas and Smith, James F., Stories vs. Statistics: The Impact of Anecdotal Data on Accounting Decision Making (March 12, 2010). Available at SSRN: http://ssrn.com/abstract=1571358

Short Term Neural Changes

1. Dopamine2. Mirror Neurons3. Amgydula

Dopamine

• Neurotransmitter substance associated with motivation and award

• Pleasure drug giving natural high when you get what you want

• Overtime, getting what you expected produces NO dopamine (brain likes the unexpected)

• Reward you expected fails to materialize, dopamine dries up

Source: Michael Shermer The Mind of the Market (Henry Hold & Co. New York, 2008) & Jason Zweig Your Money & Your Brain (Simon & Schuster New York, 2007)

Dopamine in Finance

• Short term release (15-30 minutes)• Seeking that “hot stock”• Counter with long term picture

Use stories to explain how hot picks affect a portfolio over sound asset allocation

Source: Michael Shermer The Mind of the Market (Henry Hold & Co. New York, 2008) Jason Zweig Your Money & Your Brain (Simon & Schuster New York, 2007)

Dopamine Can Be Your Friend

• Prisoners Dilemma– Trust someone so you both walk out better off– Choose to destroy your partner and walk out a big

winner– Choose to violate each other at cost to both

yourself and the other player

• Cooperative partners strongly light up for dopamine

• Become a trusted advisor!James Rilling, D.A. Gutman, T.R. Zeh, G. Pagnoni, G.S. Berns, and C.D Kilts, “A Neural Basis for Social Cooperation,” Neuron 35 (July 18, 2002): 394-404

Mirror Neurons

Same circuits light up in brain when watching someone perform a function, as doing the function (empathy)•Crying at the movies•Cringing when our favorite athlete misses a clutch shot

Source: Tania Singer Neuroeconomics Chapter 17: Understanding Others: Brain Mechanisms of Theory of Mind and Empathy Edited by Paul W. Glimcher, Colin F. Camerer, Ernst Fehr, & Russell Poldrack (Elsevier, 2009) & Michael Shermer The Mind of the The Market

Implement Mirror Neurons

• Smile!• Study of faces shown @ 1/60th

second: Happy, Sad, Neutral• Drank a “novel lemon-lime beverage”• More consumed after happy faces• AND willing to pay twice as much!• More pleasant, sincere, sociable, competent,

honest, highly-esteemed (be genuine)Piotr Winkielman and Kent C. Berridge “Unconscious Emotion,” CURRENT DIRECTIONS IN PSYCHOLOGICAL SCIENCE 2004 Vol 13 No. 3 120-123 & Sekar, Samuel Babu, Importance of Smile in Managerial Communication. Proceedings of 6th Asia-Pacific ABC Conference on Management Communication on the theme "Management Communication: Trends & Strategies“ Conducted by IIM, Ahamedabad, McGraw Hill. Available at SSRN: http://ssrn.com/abstract=976137

More mirror neurons

• Mimic body language of whomever sitting across from you

• More you seem familiar to themselves, more likeable and trustworthy you are

Source: Lindstrom, Buyology!

Amygdula

• Ancient part of the brain dealing with instinctual emotions

• Great for ancestors• Not great for modern day technology• Surges are very short

Source: Zweig, Your Money and Your Brain

Easy Tactics

The Pursuit of Happiness What keeps you up at NightAgingTime

Major Concerns

Top Priorities

[2010

Indicator 28 – Use of Time

Indicator 28 – Use of Time

Calculus of Happiness

• Understanding client personality types• Era client grew up in

10,957

Number of days in 30 years• How many cruises can one take? • How many rounds of golf can one play? • How many hours of volunteer work will you really

do?

•Important exercise: have clients create a roadmap of what might happen in 10,957 days

Summary

• Behavioral Finance being discussed • Data is there-incorporate into your client

interactions• Market volatility is forcing the conversation to

change drastically.• What behavioral traps are you falling into?

Appendix