Motivation and emotion/Book/2019/Risk taking and emotion in financial markets

Overview
How do emotions influence decision making in financial markets? When influenced by strong emotions like envy, regret, anger, schadenfreude, and joy. People are unable to accurately judge risk and make rational decisions. The impact of such emotions on financial decision can culminate in events as dramatic as financial crises. The consequences of which affect the well-being and emotional lives of billions around the world.

The psychological study of making financial and economic judgments (Behavioural economics) seeks to apply psychological theory to economic decisions. This chapter strives to develop further understanding of the effects of emotions on risk-taking and decision-making in financial markets. By understanding how our emotions, motives, and biases effect how we make choices. So that we may improve our cognitive, emotional, and motivational lives better meeting our goals and psychological needs.

Focus questions:


 * How does psychology interact with financial markets?
 * How does the brain generate emotion, motivation and risk-taking behaviour?
 * How do emotions influence decision making in finance?
 * How can financial judgement be improved with findings in psychology?


 * Case study: Emotional trading

A young man has saved $5,000 dollars. He wants to invest for his future and benefit by investing in companies, earning a share of their profits over time. He decides that Tesla is a good company and he likes the idea of being environmentally friendly with a long-term investment. He doesn't understand the risk involved of buying a stock that has grown so much over the last 5 years. He buys 15 shares of the stock at $230 dollars per share. He is excited by his decision and he feels joy that he is doing a good thing for himself and for society.

A few weeks later, Tesla receives some poor market news and its share price dips dramatically. The man, having lost 15% of the value of his investment in one day, panics. Fear, anxiety, and panic take hold of him. He decides to sell the shares, forgetting that his plan was to invest in this company long-term.

It is difficult to say what the best decision is in this circumstance. However, it is clear that the short term intense biological experience of emotion influenced the man's original goals and intentions.

The psychology of financial markets
"We are merely reminding ourselves that human decisions affecting the future, whether personal or political or economic, cannot depend on strict mathematical expectation, since the basis for such calculations does not exist; and that is our innate urge to activity which makes the wheels go round, our rational selves choosing between alternatives as best we are able, calculating where we can, but often falling back for our motive on whim or sentiment or chance."

- John Maynard Keynes, (1964)

Motivations in finance
Why do people invest in financial markets? People are motivated in finance to satisfy the basic physiological and psychological needs. By being motivated to enhance economic security there is increased freedom to pursue self-actualization, unconstrained by physiological needs (Mayall, 2010). The success or failure of financial decisions often hinges on suppressing short term wants and needs in order to meet long term goals and motivations.

Markets: A psychological perspective
Financial markets are important from an economic perspective for the operation and functioning of society. Allocating resources based on the functions of price and supply and demand in a free market. From a psychological perspective, interacting with markets involves risk-taking decisions and value judgments with high emotional valence (Statman, 2002). As the impact of financial gains and losses are intimately tied with emotional states (Lowenstien, 2010). Fortunes can be made or lost in a single decision. This drive to satisfy psychological needs, influenced by various emotional states, creates high levels of motivation in market participants (Mayall, 2010). As financial markets, like all things, are generated within the human mind, psychological theories are highly relevant when considering investing and other behaviors.

Are markets rational?
Much debate ranges on the question of the rationality of markets. It remains contested to if economic decisions are either wholly cognitive or emotional in nature (Suresh, 2013). Economics has often failed to take into account the psychological components of human decision making when developing economic models (Amir et al., 2008). The by considering motivation and emotion allows further understanding of why people make consequential financial decisions. The classical economic approach has not accounted for peoples biases, motivations, and emotions when considering the actions of people in financial markets (Kuzmina, 2010). The blending of psychology and economics allows for greater understanding of decisions in financial markets.

Do the characters in the video below respond rationally to financial incentives or their psychological needs? You decide.  Wolves on wall street (Contains adult themes)

Classic economic theory:
Homo Economicus - The Economic Man

The classical approach to economics dictates that markets operate on the basis maximising personal utility. Classic economic theory portrays humans as consistently rational. Who should act in their best interest and pursue optimal strategies if given the correct information (Amir et al., 2008). Such as always buying something at the price that best reflected their true value of the good (Figure 1.). This was considered as dogma for many years and has only recently been called into question as the prevalence of market events like bubbles continue to cause harm to societies.


 * The market economy
 * Rational-utility theory
 * Efficient-market hypothesis
 * Rational choice theory

Psychology meets finance
The classical economic worldview began to shift with the work on decision making and preferences by Amos Tversky and Daniel Kahneman in the 1970's and 80's. Experiments examining how emotions and cognition make us behave in ways that are either high-risk or irrational (Suresh, 2013) showed how people predictably make errors in their choices. Which opposes to the assumptions made in classical economics that all humans behave rationally in response to information. Below are some of the insights of research in this area.


 * Complexity
 * Herd behaviour
 * Cognitive and Emotional Biases
 * Heuristics and Framing
 * Market inefficiencies
 * Nudge theory
 * Behavioural finance

Risk and financial decision making
In financial markets the investor is making probability judgments. In which outcomes are unknown and they are required to make decisions with elements of risk (Mishra, 2014) in order to receive monetary gain. As human knowledge is finite, investing requires deciding between alternatives (making satisficing decisions) under the theory of bounded rationality. There is an element of probability and risk-seeking in investing which is comparable to gambling. Emotions have been shown to reliability inhibit effective decision making (Kahneman & Tversky, 1982). The inability of individuals to successfully predict future events in complex market systems suggest that if not rationality, then emotions are the primary drivers for risk-taking and decision making. {How does psychology differ from economics in its approach to judging human decision making? - Economics has a more mathematical and accurate model for human behaviour + Psychology understands that people can think emotionally and are not always rational in their decisions - Psychology fails to take into account the rationality of humans when making decisions - Psychology has nothing of interest to say in financial markets
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The neurophysiology of risk-taking and emotion


How is the brain motivated to take risks? What areas shape emotional states and make decisions between alternatives? What is neurophysiology's role in generation of emotion? These questions help us frame the physiological components of behaviors observed by participants in financial markets. The brain regions involved are various cortical and sub-cortical areas along with hormonal processes that influence motivation and behaviour.

The cortex
The cortex of the human brain (Figure 2.) is responsible for the higher-level cognitive functions. It deals with and makes sense of the emotional phenomena produced in the sub-cortical brain. Producing deliberative and conscious thought processes, allowing us to make decisions between alternatives (Shaw et al., 2008). The cortical regions that govern decision-making and risk-taking are the orbitofrontal, prefrontal, and anterior cortices. The dorsolateral prefrontal cortex allows monitoring, planning, and making risk judgments. Disruption to activity in this area has been shown to decrease long term planning and self-control, increasing risk-taking behaviour (Knoch et al., 2006). The orbitofrontal cortex relates to incentives and stimuli reinforcement. By assisting us in processing choices when making decisions (Rolls, 2004). The anterior cingulate cortex monitors conflicts in information processing. Interpreting basic urges and emotions to make adjustments to cognitive control so that we may make effective selections between alternatives. (Botvinick et al., 2004). The ventromedial prefrontal cortex is responsible for the ability to interpret emotional signals that are necessary for guiding decisions in an advantageous direction (Bechara et al., 1999). These areas interact to provide the ability to create goals, judge risks, self-regulate and consider how we would feel about the outcomes of decisions. All of which are important functions when making high-risk financial choices between alternatives.



Sub-cortical structures
The sub-cortical process are the more involved in the generation of strong emotional urges that rise into conscious awareness without deliberate thought. Automatic processes such as hunger, thirst, fear, desire, and reward. The sub-cortical segments of the brain that most impact on motivation, emotion, and decision making are the amygdala, dopamine-based reward circuit, and limbic system. The brain region responsible for evaluating and responding to such emotional stimuli in the environment is the amygdala (Bechara et al., 1999). Which is well known for its role in anxiety and the flight-or-fight response (Figure 3.). However, it also has a role in motivation and processing of stimuli and reward associations by predicting emotional effects of choice outcomes, helping to motivate or inhibit approach behaviour (Bechara et al., 1999).

The dopaminergic reward circuit (Figure 4.) consists of the ventral tegmental area, nucleus accumbens, striatum and basal ganglia (Reeve, 2018). These pathways are multiple structures that form the reward circuits of the brain. Encouraging choices judged as desirable by releasing dopamine (Critchley et a., 2001). Dopamine is produced in the ventral striatum and ventral tegmental area in response to stimuli that produce pleasurable feelings (Bressan & Crippa, 2005). Dopamine interacts with the nucleus accumbens which excites positive cognitive experiences and interacts with the basal ganglia to motivate potential action and movement. Over time learned responses and emotional associations with events in the environment drive us towards what we desire and enjoy (Salamone & Correa, 2002).

The limbic system is where motivation gets transferred into physical action. It receives excitation from surrounding structures to initiate approach or avoidance behaviours (Mogenson et al., 1980). These sub-cortical areas are responsible for innate and unconscious motivations (Salamone & Correa, 2002). The resulting behaviour appears consciously as our impulses, the rising desire to eat as we get hungry. These same systems are what drive us to engage in risk-taking behaviour in order to satisfy our financial needs.

Hormones
Hormones are chemical messengers released in the brain and the nervous system that send signals to the body. In order to influence organ activity and transmission of information (McEwen, 1979). Testosterone is the hormone responsible for male reproductive drive, but it has other effects on human behaviour. Studies indicate testosterone influences attachment, control, affiliation and power motivations (Schultheiss et al., 2004). It is also demonstrated to have an increasing effect on anger and risk-seeking behaviour (Apicella et al. 2008). It is no wonder that high-risk financial professions are dominated by males with higher levels of the hormone. It is a reflection of the underlying biology poorly adapted to modern times. Dopamine is thought to influence motivation through the hypothesis of reward. Which mediates behaviours by modulating mood in order to form associations with positively perceived environmental events, reinforcing behaviour (Bressan & Crippa, 2005).

{Which brain region helps us plan our choices, monitor, and make judgements about risk? - The amygdala + Dorsolateral prefrontal cortex - Basal ganglia - The dompaminergic reward circuit
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Emotion and finance


Research on the brain shows how emotional states and motivations are generated. What exactly are emotions at the level of experience? How do they influence behaviour and decision making? A functional definition of emotion that is universally accepted has not yet emerged in the literature. However, consensus is that emotions exist and contain key characteristics, Ackert et al. (2003) outlines six features central to emotions:


 * Cognitive antecedents
 * Intentional Objects
 * Physiological arousal
 * Physiological expression
 * Valence
 * Action tendencies

Emotions can be described as short lived feeling-expressive-bodily responses that help us adapt to the opportunities and challenges that we face during important life events (Reeve, 2018, p. 288). The James-Lange theory of emotion explains how the physical reactions brought about by stimuli create an emotional experience (Figure 5.). Emotions influence decision making by our appraisal of that emotion. We approach or avoid based on how we feel about the experience of the emotion (Lazarus, 1999). We are driven towards behaviours by emotions that make us happy and away from negative emotional states (Figure 6.). While emotions are adaptive in helping us deal with our environment and important life events. Financial markets are unlike anything we prepared for during our evolutionary history. Therefore, some of the emotional influences that assisted us in avoiding large land-based predators function poorly when making decisions in modern finance (Ackert et al., 2003). Emotions drive decision making and risk-taking in finance in some of the following ways. The brain is in conflict between its sub-cortical structures and the higher level cognitive functions of decision making generated in the cortex. The balance between instinctive wants and desires (possessions, resources and financial incentives) and rational decision-making (long-term goals, plans, investment strategies) is important to understanding the effects of emotions on choice in finance. Innate emotions such as happiness, anger, joy, triumph or fear are generated in the limbic system in response to reactions to particular stimuli (Kuzmina, 2010). The dopamine response generated by gains or losses in financial markets hijacks the cognitive aspects of the brain (Statman, 2002). Such primary emotions are in opposition to the deliberative and cognitive styles of thinking required for complex decision making (Shiv et al., 2005). Emotions such as anger or frustration that evolved to drive action in an organism can cause investors to be impatient and increase the likelihood of risky decisions (Ackert et al., 2003).

Socially driven emotions influence decisions with group based effects such as herding and irrational exuberance (Steinbock, 2003). Perceived outcomes of interactions with social groups significantly influences decision making and risk-taking (Kuzmina, 2010). This is reflected in emotions like the fear of missing out comparative to others. Social behaviours like interpersonal competition and status seeking are driven biologically by testosterone and have a strong emotional component (Schultheiss et al., 2004). Emotions like pride and triumph directly relate to perceptions of gains or losses and are also strong social motivators of risk-taking behaviour (Knutson et al., 2008).

Emotions influence more with visceral environmental factors, as is the case with with financial markets. The effects of emotional influences on decision making are proportional to the intensity of the factors triggering that emotion (Loewenstien, 2000). For example food is always tastier when hungry, warmth feels more pleasurable when already cold, and a monetary gain/loss is more arousing when significant or immediate. Emotions such as envy or joy are particularly significant in modulating the level of risk after experiencing financial gain (Mayall, 2010). Conversely, anticipated emotions such as regret or sadness also influence someone to make irrational or risky decisions based on perceived loss (Lowenstien, 2000). The example of investors (and gamblers) doubling down on a bad bet is an archetype of such effects.

{How does emotion influence decision making at the level of experience? - Cognitive processes allow us to suppress all emotions and make rational decisions - Cognitive processes stop the feeling of emotion and make it hard to make risky decisions - Emotions assist cognitive processes that arise from the limbic system in response to stimuli + Emotions disrupt cognitive processes in response to significant stimuli
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Emotional biases
"Only two people know the top and bottom of a market. God and a liar"

- Vijay Kedia

As people often make poor decisions when experiencing emotions. Inherent patterns of thinking and emotion can be shown to cause predictable errors called biases (Gilovich et al., 2004). These phenomena influence thinking, even more so when they are tied to strong emotional states (Shiv et al., 2005), as is often the case in high-risk financial decisions (Ackert et al., 2003). They are the primary sources of error when making financial decisions (Misha, 2014). Here are some various examples of emotional biases that influence decision making and risk-taking behaviour. {A particular stock has just dipped in value, therefore you think that it must increase in value again in the future. The manager of the company is also incredibly competent because he always wears the finest suits. Which two biases are you demonstrating? + Halo effect and gamblers fallacy - Anchoring and availability - Overconfidence and risk aversion - Optimism and confirmation bias
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Improving financial decision making
How can psychological research help us make better decisions in spite of our emotions? There are a number of approaches to limit the influence of emotions on decision making. A useful way to counteract the impact of biases on our thinking is to use emotional regulation strategies. That involve modulating ones own behaviour or environment to reduce the biological or physical aspects of an emotion. Another way to improve financial decision making is to have a process to identify, monitor and evaluate risks. This process is usually understood as risk management. Skilled investors often employ cognitive strategies in order to limit the effects of emotions on their decision making. Examples of this include having set rules when conducting investing behaviour, often involving self-analysis of emotional states to reduce excessive emotional influence on thinking (Shiv et al., 2005). Long-term cognitive strategies include setting financial and savings goals that limit the effect of short term desires. Or only investing a certain amount of available resources with any decision. The attempt to understand and apply more rational ways of making economic and financial decisions is understood as Rational Choice Theory. These are the various ways people, societies, and psychology help us to improve our choices under uncertainty.

Conclusion
Emotions influence financial decision making by the warping of judgement through predictable errors in thinking called biases. Study in behavioural economics has increased our understanding of how emotions influence decision making. There are neurological adaptations as to why emotions influence us the way they do. Our physiological and psychological needs drive us towards competition and makes us desire resources, even when at significant risk. In financial markets, emotional biases hinder our ability to make the best possible decisions under uncertainty. Emotions affect us due to the conflict between the instinctive and cognitive areas of our brain. The fact that financial decisions are tied to money, which has a high emotional valence, increases this effect. Our social mechanisms further hijack our rational thought processes by causing us to alter our thinking based on the influence by our peers.

In better understanding of the cartography of our emotional blind spots, so poorly adapted to modern life and finance. Study in our emotional biases will help us make better judgement under uncertainty, improving our motivational and emotional lives.