Financial risk-taking has a neurobiological basis.
That’s the conclusion of two experts in neuroeconomics and behavioural finance – Camelia Kuhnen and Brian Knutson – who co-authored a compelling paper called The Neural Basis Of Financial Risk Taking.
Their discoveries were covered recently in an issue of Financial Advisor1 (originally published January 2, 2014) written by Thom Allison and Andre Golard.
The subject makes fascinating reading, not least because the work helps us understand an issue I’ve written about in the past: loss aversion. This, as many of you know, is the tendency for individuals to prefer avoiding losses rather than accruing gains.
Originally proposed by a pair of Israeli psychologists, Amos Tversky and Daniel Kahneman, loss aversion stands at the heart of financial decision-making. They wrote a scholarly treatment of the issue called Prospect Theory2: An Analysis of a Decision Under Risk and their approach has spawned an expanding literature on risk taking.
Why we hate losing
Going beyond Tversky and Kahneman’s original conclusions – which were psychological – Kuhnen and Knutson dug deeper and unearthed losing’s neurobiological foundations. Their conclusion?
We hate losing because we’re hardwired to do so. It’s that simple.
Kuhnen and Knutson state: ‘a broad set of brain areas is activated in response to gains, including the ventromedial prefrontal cortex (associated with decision-making and learning in the context of reward and punishment), and the ventral striatum (associated with learning, motivation and reward).’
Kuhnen and Knutson conclude, in the same study, that ‘the activity of the same areas decreases with losses.’
According to Thom Allison and Andre Golard, again quoting Kuhnen and Knutson: ‘The sensitivity to losses disappears in individuals with damaged amygdalae (part of the limbic system activated when we experience fear).
Other studies have shown that the amygdalae are involved in decision-making. Knowing that the amygdalae are involved gives us an important clue about how we may deal with loss aversion.’
Conclusion: riding losers too long
Neurobiologists have discovered that any thinking that comes out of our limbic system happens very quickly and mostly unconsciously.
Loss aversion, being hardwired into our network of our rapid response instincts, is – more often that not – spontaneous and ferocious.
Put another way, we hate losing far more passionately than we love winning. That’s why we hold on to losing investments when we know we should ditch them.
Riding losers too long is a tough compulsion to break. But knowing just how fundamental it is to our neurobiological make-up can go a long way to helping us do so.
Dave Ritcey, The Ritcey Team, Scotia Wealth Management