Neurofinance And The Brain Science Behind Investment Decisions
Neurofinance, a popular field of science in recent years, has produced fascinating studies demonstrating the correlation between the human brain and investment decisions.
These studies offer insights that both brands and financial institutions can draw inspiration from. Even professional investors’ investment decisions involve not only rational planning but also neurofinance factors such as emotions, hormones, and stress.
In recent years, advancements in brain imaging techniques such as fMRI have made it possible to more clearly observe an investor’s feelings about market fluctuations and the reactions of their brain’s reward mechanism during investment processes.
Thanks to these advancements, we can demonstrate the impact of people’s dopamine systems, amygdala, and rational evaluation processes on investment decisions. We know that there are direct changes in certain parts of the brain, particularly the prefrontal cortex.
Quick Note ↵ As more research in neurofinance continues, it will become easier to combat panicked investing and stress in the face of sudden fluctuations by developing a professional approach.
However, people need to use their own brain awareness effectively, be patient and disciplined, and most importantly, develop their financial literacy regardless of their investment model, being open to continuous learning and change.
Only then can we remain strong against financial systems that seize control of our brains through neurofinance manipulation.
What Is Neurofinance And How It Explains Investment Behavior?
Neurofinance is a modern scientific discipline that demonstrates the relationship between the human brain and financial decisions and examines the cerebral mechanisms behind human investor reactions.
Studies in this field generally demonstrate that investors make investment decisions not only based on rational considerations but also on motivations such as chemical reactions, hormones, and emotions.
The brain’s reward mechanism is frequently stimulated during investment processes, and sometimes, especially during sudden market fluctuations, irrational and radical investment decisions can be made.
While the fear of loss in the human brain is a fundamental mechanism that enables actions consistent with risk tolerance, sometimes disruptions in brain chemistry can lead to an excessive focus on high-return expectations.
In such situations, investors can make irrational choices without considering the risk-return balance. In such cases, it is recommended that a conscious investor always employ risk management strategies, set realistic goals, and avoid being captivated by hormones and emotions.
The Role Of Neurofinance In Understanding Risk And Reward
In the field of neurofinance, the perception of risk and reward can be explained as a chemical process that enables the brain to maintain many functions. The human brain’s perception of reward and risk is activated by dopamine systems.
This mechanism also applies to financial decisions and investment processes. Neurofinance research has generally observed that many investors lose potential profits due to fear of loss, and many more lose their existing capital due to unrealistic expectations of return.
Therefore, to avoid a decline in our quality of life and financial stability, we must accurately analyze the balance of risk and reward.
How Neurofinance Links Emotions And Investment Decisions
Dozens of experiments and research in the field of neurofinance have demonstrated a strong correlation between emotions and investment decisions.
Numerous experiments have demonstrated that emotions such as stress, fear, and greed often trigger reactions in the human brain when making investment decisions, directly shaping them. Sometimes, elevated stress hormones can make it difficult to think rationally and logically.
In such situations, investors often take actions aligned with short-term return targets. Furthermore, as stress levels rise, it’s possible that reasoning skills in certain parts of the brain slow down, leading to poor investment decisions.
Neurofinance Insights On Overconfidence In Trading
One of the flaws in every investment model is overconfidence. According to neurofinance researchers, if an investor is overconfident in their own knowledge and experience, they are more likely to make poor investment decisions in the medium and long term.
Therefore, a more disciplined and long-term investor would benefit from a realistic assessment of their own knowledge and experience, based on market realities, without taking excessive risks.
The Contribution Of Brain Imaging Studies To Neurofinance
Misconceptions such as loss aversion, maintaining the status quo, and sunk costs are just a few examples of misconceptions that play a significant role in student choices.
Therefore, cognitive misconceptions, which influence students’ choices and, through these choices, their lives in both the short and long term, and offer opportunities to better understand their behavior, are an area that education researchers should focus more on.
Developments in psychology, which attempts to explain human behavior centrally and its implications for economic decision-making, led to the reshaping of economic theories starting in the second half of the 20th century.
As psychologists succeeded in methodologically examining the underlying causes of human behavior, neurofinance emerged as a new, multidisciplinary field of study that encompasses the influence of psychological factors on economic decision-making.
Neurofinance strives to provide a more realistic framework for economic models by incorporating the psychological dimension into human behavior.
The “economic man,” considered the starting assumption of neoclassical economic theory, is an individual who makes choices based on rational decision-making, always considering their own benefits and interests, and who, in doing so, is able to protect themselves from systematic errors.
In this scenario, people choose the option that will provide them with the greatest benefit. Based on this, a person capable of making rational decisions is also considered to possess self-control.
However, empirical studies have demonstrated that this behavioral model of the economic man does not correspond to behavioral patterns encountered in real-life situations, necessitating a reconsideration of the assumptions based on the “economic man” concept.
Neurofinance And The Psychology Of Long-Term Investing
A new field of study in economic theory, known as neurofinance, seeks to place real-world behavior patterns, deviations from ideal behavior observed in these behaviors, failures, and errors at the center of economic analysis.
The aim is to increase the degree of accuracy and quality of economic analyses, which will lead to a better understanding of human behavior and the formulation of better policy recommendations.
Neurofinance has revealed that neoclassical economic understanding is inadequate to explain, that people can systematically make decisions that are incompatible with the rational model when under uncertainty and risk, and that it is necessary to include elements such as psychology and sociology in the analysis to make sense of these irrational decision mechanisms.
How Neurofinance Helps Identify Cognitive Biases In Finance?
Optimization theories, which economics considers axiom-based and the cornerstone of economic analysis, do not need to be abandoned entirely.
However, to predict actual human behavior, additional descriptive theories are needed, developed from data rather than axioms, and developed to refine optimization theories.
The findings obtained by neurofinance, by incorporating human behavior into analyses in areas where other economic models fail to explain, allow for much more successful economic analyses.
This success stems from this new movement’s broader approach, which transcends the boundaries between the behavioral sciences and integrates scattered elements within these fields.
In analyzing behavioral anomalies, new and more realistic conclusions are sought by integrating findings from cognitive psychology, social psychology, psychophysiology, evolutionary economics, sociology, and even neurology with economic theory and hypotheses.
The behavioral approach is concerned not only with the choices people make, but also with why they make them and how and to what extent these processes influence their predictions, decisions, and actions.
Thus, by revising the assumption of rationality, a more realistic understanding of human behavior is achieved. Humans are creatures with psychological and behavioral characteristics such as emotions, intuition, and prejudices.
Under uncertainty, people can systematically violate the fundamental probabilistic principles envisioned by neoclassical economics by employing emotional filters and shortcuts, and because they make predictable errors, they are considered to exhibit irrational behavior.
The systematic and predictable nature of these errors allows them to be studied. In behavioral finance, research has shown that strategies based on psychological information can increase profitability within investments.
Furthermore, research shows that the best behavioral strategies are long-term. While behavioral assessments may not provide a tremendous performance advantage, they provide a crucial key to helping individuals rise above their own threshold in a world where most fund managers underperform the market year after year.
Many investment strategies initially considered “behavioral,” such as value investing or momentum investing, have now become a part of finance. Research shows that active investment management often results in a losing outcome for both individual and professional investors.
For individual investors, investing in index funds is particularly suitable because risk management is easier than a portfolio composed of individual stocks.
A diversified portfolio can be created by creating a balanced basket of different index types—sectoral, international, currency, and commodity.
Buying and holding index funds for the long term is the most profitable investment plan for most investors. Of course, as long as they don’t frequently monitor fluctuating prices.
The Future Of Neurofinance In Behavioral Economics
The approach called New Neurofinance was shaped between 1970 and 1990 as a result of the methodological and theoretical contributions of the developments in cognitive psychology and cognitive science to economic studies since the 1960s.
In economics, the assumption that decision-making units behave rationally is a critical assumption for achieving optimal solutions, meaning the “best” solution.
Although neoclassical economic analysis placed human decision-makers in various roles at the center of the economic model, it long excluded psychology, which placed human behavior and the underlying mechanisms at the center of its purview.
To address this gap in understanding and explaining human behavior, psychologists, drawing on the theories and methods of cognitive science and cognitive psychology, as well as economic theory, have jointly established the new multidisciplinary field of neurofinance with economists.
The psychological theories and approaches introduced by neurofinance have enhanced the realism and explanatory power of economic models explaining human behavior.
Case Studies Demonstrating Neurofinance In Investment Decisions
In the 2000s, particularly following the development of concepts such as nudge and choice architecture, it has been argued and demonstrated that nudge policy tools can guide people toward more sustainable consumption behaviors.
Neurofinance is a field that can yield such effective results that both major financial platforms and brands are launching various advertisements and campaigns to trigger this chemistry in the human brain. Neurofinance has a significant impact on any investment model or financial decision a person makes.
Through nudge policies, consumers can reduce their negative impacts on the environment by consuming healthier foods, shifting to more environmentally friendly energy consumption patterns, and increasing recycling efforts.
Thanks to nudge policies, it seems possible to achieve positive developments in important macroeconomic indicators such as the savings-investment balance.
It can be said that there are currently over a hundred cognitive biases and heuristic methods studied within the discipline of behavioral finance.
New cognitive biases and heuristic methods are emerging every day with studies in the relevant field. Inferences are generally drawn from findings obtained by observing investors’ self-reports and behavioral patterns in behavioral finance research.
However, some recent studies have indicated that hidden motives, subconscious processes, and factors consumers are unaware of are much more influential in people’s decisions.
Therefore, innovative data collection methods that measure these factors by measuring brain and body responses have begun to be used in recent years.
This scientific discipline is called neuromarketing. In recent years, devices used in neuromarketing have also begun to be applied in scientific disciplines such as management, education, economics, finance, and the arts.
These studies conducted in finance are called “neurofinance.” This blog provides some examples of how neuromarketing tools can be applied in finance and what inferences can be drawn from the findings.
Why Is Neurofinance Becoming Important In Financial Education?
In recent years, consumers/investors have been exposed to countless messages throughout the day. However, consumers/investors have sufficient time to engage with each message.
Therefore, messages delivered to consumers/investors should be simpler, more engaging, and easier for the target audience to understand.
Creating a message that investors can easily understand is also quite challenging, as numerous hidden motives and factors underlie purchasing decisions. Consumers/investors, however, are often unaware of these hidden and subconscious motivations.
Therefore, methods that measure subconscious processes are needed to reveal the factors influencing investors’ financial purchasing decisions.
These methods, which can measure subconscious processes to reveal the factors influencing financial purchasing decisions, have recently been incorporated into the discipline known as neuromarketing/neurofinance.
Methods such as EEG, eye tracking, facial muscle emotion recognition, heart rate measurement, and galvanic skin response can measure consumers’/investors’ subconscious emotions in response to stimuli.
Data obtained by using multiple data collection tools together is processed with advanced statistical methods, artificial intelligence, machine learning and deep learning methods, contributing to the acquisition of more generalizable, more valid and more reliable results.
See you in the next post,
Anil UZUN