Five Ways Your Brain Can Sabotage Your Investing

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The stock market is a great brawl in which minds with opposing views battle over whether prices will go up or down. Unfortunately, investors are often their biggest foe in this arena because our brains have biological mechanisms to screw us up.

Here are five reasons the self-sabotaging brain does this.

1. The drive to defend: Our brains love being right and hate being wrong.

In their book, "Driven: How Human Nature Shapes Our Choice," Harvard Business School professors Paul Lawrence and Nitin Nohria assert that humans are guided by four drives: acquiring, bonding, learning and defending. We have an innate instinct to defend ourselves, family, possessions and beliefs. As a result many investors tend to stick with a losing trade, because they can't admit that they're wrong.

In the modern age, being told we're wrong is as physiologically threatening to our bodies as a lion was to the Neanderthal. "Being wrong or thinking you are wrong causes stress, which triggers stress hormones such a cortisol or epinephrine," explains Dr. Janice Dorn, a psychiatrist and co-author with Dave Harder of the forthcoming book "Mind, Money and Markets."

"These neurotransmitters, if not shut off fairly quickly, cause damage to the body through a variety of processes, including, but not limited to, elevated heart rate, increased respiration, mobilization of the body for fight or flight, and inflammation," she said in an email.

Conversely, proving that we're right triggers an addictive neurochemical process, Judith Glaser, CEO of Benchmark Communications, wrote in a blog for the Harvard Business Review .

"When you argue and win, your brain floods with different hormones: adrenaline and dopamine, which makes you feel good, dominant, even invincible," Glaser wrote. "We get addicted to being right."

Harvard economist John Kenneth Galbraith was known for saying: "Faced with the choice between changing one's mind and proving there no need to do so, most people get busy on the proof."

To combat the addiction to being right, Glaser recommends planning your actions or outlining rules of engagement beforehand. This means investors should plan ahead of time when and why they would buy or sell their position.

2. The backfire effect: It's difficult to admit we're wrong even when the facts prove we are.

We humans have a limited capacity to process information, and even facts don't have the power to change people's beliefs. Political scientists Brendan Nyhan and Jason Reifler observed in an experiment that self-identified conservatives remained adamant that Iraq had weapons of mass destruction even after receiving evidence to the contrary. Likewise, liberal-leaning subjects ignored facts that the Bush administration's restrictions on stem-cell research were limited rather than banned completely.

When our beliefs are proven false, we can fall prey to a phenomenon that Nyhan calls "backfire effect"  -- "a natural defense mechanism to avoid cognitive dissonance." His research has found that people grip onto their beliefs even tighter when shown the facts because it feels so threatening to be wrong.

3. Confirmation bias: We tend to see only what we're looking for.

Most of us want to believe that we're open-minded and form opinions based on evidence and rationalization. But we have a natural tendency to favor information that agrees with our beliefs, regardless of the facts. "Confirmation bias" makes us selectively shun information that disagrees with our preconceived notions.

Hence, conservatives prefer Fox News over MSNBC and vice versa for liberals/progressives. Both sides of the global-warming debate can look at the same temperature readings and draw polar-opposite conclusions. Studies on wine drinkers show the more expensive they think a wine is, the better it tastes. This phenomenon applies to everything, Dan Ariely, a behavioral economist at the Massachusetts Institute of Technology, says in his book "Predictably Irrational."

"Confirmation bias is the tendency to search for and overweight anything that favors one's own position," Dorn wrote. "This bias causes traders or investors to become overconfident in their positions and stay in these positions long after they should have exited."

"They will continue to seek confirmation that they are correct and often sell only when the pain of loss becomes too much to bear," she added. "Even then, in the face of being clearly wrong, the investor will find something or someone else to blame."

4. Wishful thinking: We believe what we hope to be true.

We often hold beliefs just because they're what we desire to be true, despite reality or evidence to the contrary. There's no doubt we have the power to make some desires come true, but the markets are more powerful than all of our desires and wishes.

"It is more important to follow what the money is actually doing than what we think it should do," Dave Harder, co-author of "Mind, Money & Markets," who has more than 30 years of experience as a portfolio manager, wrote in an e-mail.

All things being equal, we are more likely to predict positive outcomes than negative ones. Fans tend to think their team is better and more likely to win. Many buy lottery tickets even though the chances of winning are often 1 in several hundred million.

"We cannot impose our needs or wishes on the markets, and it is foolish to do so," Dorn wrote. "The markets don't know who we are and don't care what we think or believe. Legendary trader Jesse Livermore wrote as one of his trading rules in 1940: 'Wishful thinking must be banished.' "

5. Illusory correlation: We are pattern-seeking primates.

We have an inherent need to make sense or find an explanation for everything we experience, even though events may be random -- a phenomenon called "illusory correlation." Once we've decided a connection exists between different things, we look for information that confirms our belief.

Fishermen who catch many fish in one part of the lake are quick to conclude that's the sweet spot, even though it could have been a fluke. A Midwesterner who gets rude treatment in New York City might generalize that everyone in the Big Apple is rude.

Gold investors assume that rising government deficits, dollar debasement and central bank stimulus increase gold prices even though gold plunged 28% last year as the Federal Reserve boosted quantitative easing and the U.S. debt hit a historic record.

"It can't be proven that this was a cause-and-effect phenomenon," Dorn wrote. "If it were this easy, there would be no markets since everyone would be thinking and doing the same thing."

Even if there was a correlation between gold prices and quantitative easing in the past, there's no certainty that there will be in the future. What's more, the economy has an infinite number of moving parts at play and the environment constantly evolves. Unlike science, economics can never isolate a given set of variables in a vacuum to prove that one thing leads to another.

"In a complex adaptive system such as the stock market, it is easy to identify correlations when they do not exist or exist only on occasion," Dorn wrote. "One of the most common errors that investors make is to confuse luck with skill."

Follow Trang Ho on Twitter @IBD_THo .



The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of The NASDAQ OMX Group, Inc.



This article appears in: Investing , ETFs

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