When researchers delve into the forces that influence investors’ decision-making, they find everything from evolutionary imperatives to deep-sea wildlife.

If you’re an investor facing a dilemma that requires bold decision-making, the first thing you should do is move as far as possible from anyone with a tuna sandwich.

It may seem a strange suggestion but research by Spike Lee and Norbert Schwarz, published in the Journal of Personality and Social Psychology in 2012, found people had a 24 per cent reduced appetite for investment in the presence of the smell of fish. It turns out there is measurable truth in the old adage ‘there’s something fishy going on here’.

“So if you’re a financial planner, don’t serve fish,” said Kathryn Kaminski, the chief research strategist and portfolio manager at AlphaSimplex Group, at a roundtable sponsored by Natixis in Sydney in October. “It gives you an interesting perspective that sometimes the things that you think don’t affect decisions actually do.”

Neurofinance is an emerging research field that tries to better understand the mechanisms that drive behaviour in financial markets.

Until the day comes that artificial intelligence takes over the decision-making on the trading floor, human minds will continue to dominate investment decisions around the world. And this emerging field – a blend of economics, neuroscience and psychology – is delivering some startling insights that could enable investors to better handle the decisions they face.

Kaminski, who in addition to her role at AlphaSimplex is a senior lecturer at the Massachusetts Institute of Technology, explained the way mechanisms that developed over millions of years of evolution now influence investment decisions. Some findings were particularly counterintuitive.

It turns out, for example, that it’s important for investors to be in touch with their emotions.

Research by Lisa Barrett and Myeong-Gu Seo, published in the Academy of Management Journal in 2007, challenged the common view that feelings are generally bad for decision-making. They found individuals who experienced more intense feelings achieved higher decision-making performance.

“Individuals who were better able to identify and distinguish among their current feelings achieved higher decision-making performance via their enhanced ability to control the possible biases induced by those feelings,” Kaminski said their research showed.

In 2010, in The Journal of Finance, researchers Antoine Bruguier, Steven Quartz and Peter Bossaerts examined the states of mind of individuals who were successful in predicting stock patterns and stock returns.

Counter-intuitively, it wasn’t the part of the brain mathematicians would consider the most important in stock picking – that associated with probabilistic reasoning. Instead, the most useful asset to outperforming was understanding how other people would react to other individuals.

So this gives some sense to how theory of mind is an important part of finance, because we are interacting with other humans,” Kaminski said.

In 2005, Stanford researchers Camelia Kuhnen and Brian Knutson conducted MRI scans on investors to look at how different parts of their brains reacted to losses and gains. They found the results differed widely among investors, with some people reacting more strongly to loss and others to gain. This was directly linked to how they managed their financial portfolios.

And John Coates and Joe Herbert, in 2008, looked at traders and the role of hormones such as testosterone and cortisol. They found the level of testosterone in traders was predictive of their performance throughout the day.

“We really are emotionally and physiologically connected to markets and the risks we take,” Kaminski told roundtable attendees.

Participant Charles Wu, General manager, asset allocation, State Super, asked a question regarding the power of narratives in the market.

“Could it be that the narrative [of common knowledge or common ideas] keeps markets going?” Wu asked.

Kaminski said: “trend-following works very well when the world is changing  and people don’t like it. So your goal is  to measure where the market is moving.
We don’t have to have an opinion. We’re not projecting, we’re not forecasting that this is going to happen. We’re just deciding how we’re going to react in different scenarios.”

Illogical behaviour

People make irrational choices all the time, in life and in markets, but there may be some sense behind this.

One example of seemingly irrational behaviour is called ‘probability matching’. If participants are given a coin that has a 75 per cent chance of landing heads-up, are told they will get $1 for every correct call and are asked to predict a series of results, many will predict a line of results that matches the stated probability – mostly heads but with some tails thrown in here and there.

The profit maximising strategy would be simply to predict heads all the way.

Why do people do this? One theory, Kaminski explains, is that as we evolved, we encountered situations where choices that were bad for some individuals were ultimately crucial for the continuation and adaptation of the species as a whole.

She talked about a bird that had to make one choice in life – whether to nest in the mountain or the valley.

Most of the time, nesting in the valley is the best decision because it is lush and verdant, and the bird can nest and have offspring even if it doesn’t rain. Those that nest in the mountains will be in big trouble if it doesn’t rain.

But every 40 years or so there is a flood that kills all the birds in the valley.

The odds are clearly in favour of the birds that choose to live in the valley and any “optimised, smart bird” is going to make that choice for its own survival. But taking a step back and looking at it from the perspective of the whole system, the 40-year flood would wipe out the whole species if they all chose the valley. A bird species that randomises its choices, so the majority choose the valley but some choose the mountain, ultimately ends up succeeding over a species that doesn’t.

Another participant, Pauline Vamos, chair, CIMA society, asked how pension funds could use this example to help their members but also to assist their trustees in monitoring the potential behaviour of their own fund managers.

Kaminski replied: “Biology and understanding emotion is going to help us more than we ever thought. Understanding bias, understanding a predisposition for certain things can actually help us.”

Behavioural biases, Kaminski said, exist for a reason.

This forms the basis of MIT professor Andrew Lo’s adaptive markets hypothesis, which applies the principles of evolution to the interactions that take place in financial markets. Lo is the founder of AlphaSimplex Group.

In making decisions, humans take a heuristic approach – meaning a practical method such as a mental shortcut, educated guess or intuitive feeling – which isn’t necessarily the optimal choice.

When resources are available in the form of positive returns, investors adapt to take advantage of them, competition increases and yesterday’s alpha becomes today’s beta. When competition gets too intense or the market finally

tanks, it is those with the best-suited heuristics who adapt and create new strategies, while others go down with the ship.

“So this type of cycle is what we see exactly in our financial markets, in that the investments that we choose, they wax and wane over time depending on what’s available, and what resources we can find, as well as how stiff the competition is, and the particular market ecology we’re dealing with today,” Kaminski said. “So in an adaptive-markets world who wins? It’s the market players who apply the best heuristics, those who are most able to effectively adapt and compete, who outperform other market participants to survive and continue.”

What does this mean for investing?

Sally Loane, the chief executive of the Financial Services Council, mentioned the struggle to get younger Australians to “think about their future self and engage with finance”.

Kaminski said “it was a classic problem”.

“The job of people who are thinking about the pension is [to determine] how to look at what people do and what mistakes they make and how painful it is for them, then ask, ‘How do we set up a system so that they make better decisions without even thinking about it?’ ” she explained.

This approach can help investors understand a range of phenomena in financial markets, Kaminski said.

Firstly, alpha begins with a novel technique that ultimately becomes popular, creating the constant need for new approaches.

Shocks in financial markets are not anomalies. Rather, they’re an integral part of the financial ecosystem evolving over time.

And finally, investors have to be as adaptive as possible to succeed.

“We all need to think about how we can develop adaptive approaches in investment techniques, so we can adapt to changes and challenges in the financial system,” Kaminski said.


When researchers delve into the forces that influence investors’ decision-making, they find everything from evolutionary imperatives to wildlife.

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