Human Brain and Decision-Making


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Human Brain and Decision-Making

  1. 1. Human Brain and Decision-MakingFactors behind Investor Choices August 9th, 2011Dear Friends, In research conducted by Loewenstein & Kalyanaraman (1999), a group of people wereThe age old phrase: “You Reap What You Sow” asked to pick one movie (out of 24 titles) foremphasizes the fact that it is very important to the same night, one week later and two weeksmake the right choices now to reap the desired later. These movies were broadly classified intobenefits later. But making a choice is not always two segments:easy. Today’s world offers so many options ineverything that a simple decision--like ordering  Highbrow (e.g. Schindler’s List)from a menu at a new restaurant--becomes a  Lowbrow (e.g. Four Weddings and atime and effort consuming process. Funeral)Every available choice in a decision making About 66% of the group picked a lowbrowprocess offers a level of utility to us. Utility (or movie title to watch on the same night. Whileexpected utility) can be defined as the level of choosing a movie for next week, only 34%relative satisfaction that can be achieved from picked a lowbrow movie. When they werethe outcome (or expected outcome) of a asked to pick a movie to watch two weeks later,decision. 29% of the group chose from the lowbrow titles.There are many factors that can affect theutility associated with an option. But one of the The results indicate that people appear to havemain factors that affect the utility of an option a preference towards immediate rewards andis the time delay between making a decision discount the value of all delayed benefits.and receiving its outcome or benefit. Theresearch that we cover in this newsletter deals To get a clearer understanding of how theprecisely with how utility varies with time increase or decrease in time affects the utilitydifferences and how our brain makes decisions of a choice, let’s take a look at anotherbased on it. We first discuss some ground experiment by McClure, Ericson, Laibson,breaking experiments and results in decision- Loewenstein and Cohen, 2007.making, then we link those results to makinginvestment decisions and finally, based on theresearch, we suggest some best practices toimprove financial decision-making.‘Tonight I want to have fun; Next week Iwant things that are good for me’ © 2011 Bourbon Financial Management, LLC. All Rights Reserved. +1 312 909 6539. 1
  2. 2. The Effect of Time Delay on Decision b) The second observation was that short termMaking: discounting was greater than long term discounting. In other words, a delay of 5In this experiment a group of extremely thirsty minutes between now and receiving actualpeople, were presented with the choice of two benefit was a bigger factor in deterioratingoptions: the utility of a choice than the same One cup of orange juice immediately. difference 20 minutes into the future.* c) A choice that appears to be rewarding to Two cups of orange juice after 5 minutes. the brain may not necessarily be a result ofAlthough the common notion may be that a analytical thinking. It could also be a resultgreater quantity is preferable, the results of emotions. For example, the decision tostrikingly differed from this expectation.. About have a slice of chocolate cake instead of60% of the group chose to immediately have fruit salad, when following a low calorie dietjust one cup of orange juice. In this situation, is not a logical decision but is based onthe 5 minute time gap played a huge role in feelings of temptation.diminishing the utility of two cups of orange Another experiment quoted in research byjuice relative to just one cup--even though the Choi, Laibson, Madrian, Metrick (2002)quantity possible was plainly greater in the demonstrates a similar behavior where thesecond option. In another round of a similar subjects of the experiment do not make logicalexperiment, the thirsty subjects were given a choices even when it concerns their owndifferent set of options: savings. In a survey that was conducted One cup of orange juice after 20 minutes amongst 590 employees of a company, each Two cups of orange juice after 25 minutes. employee was asked the following two questions:When given the above set of choices,approximately 70% of the people chose the  Do they feel they are saving too little?second option. In this scenario the utility of  If yes, then would they raise their savingshigher quantity of juice was not diminished by a rate in the next 2 months?5 minute difference. Remarkable! Isn’t it? This 68% of all the 590 employees thought that theyexperiment helped establish the relationship were saving too little. Despite this initialbetween the delay in the reward and answer, of 590 people surveyed, only 24%discounting of its utility. There were two planned to raise their savings rate. After twoimportant observations from this experiment: months, administrative data on their savingsa) The first observation was that the human was collected to find out how many people brain discounts the utility of a delayed actually increased their savings. Surprisingly, reward. only 3 percent of all those who were surveyed, actually followed through on their thoughts. © 2011 Bourbon Financial Management, LLC. All Rights Reserved. +1 312 909 6539. 2
  3. 3. The result defied logic. Even though 68% of the are two separate neural systems in the brain,group felt their savings were low, only 3% took the Mesolimbic dopamine (M-D) system andmeasures to increase their savings. the Fronto-parietal (F-P) system.This behavioral phenomenon suggests that The M-D neural system was found to bedecision making by a human mind is affected involved with emotional activities and wasby many other factors and not just for more active when the subjects chose smalleranalytical reasons. and immediate rewards.*Ramsey (1930s), Strotz (1950s), & Herrnstein (1960s) were thefirst to understand that discount rates are higher in the short The F-P neural system was more active whenrun than in the long run. larger, delayed rewards were chosen which required analytical thinking.Decisions: Products of Analytical &Emotional Brains These two systems operate in conflict with each other. The brain then makes a decision based on the combined effect of the activity in these two systems For 14 female thirsty test subjects presented with delayed juice and water rewards, McClure, et al. observed neural activity which implied that brain areas produced a discount factor of 0.96/minute. Referring to our earlier example then, a discount rate of 0.9625 = 0.36; 0.9620 = 0.44; and 0.9605 = 0.82. (An 18% loss from the zero to 5th minute, versus a am 8% loss from the 20th to the 25th minute.) Perceived value declines steeply in the near term, but soon levels off to an analytical value. Or, in simpler words, all decisions, choices and actions are affected by both of these neural systems.Researchers are beginning to measure howpeople perceive time and discount value withfMRI scans. In a scientific study of human brainactivity (McClure, Laibson, Loewenstein, andCohen Science, 2004), it was found that there © 2011 Bourbon Financial Management, LLC. All Rights Reserved. +1 312 909 6539. 3
  4. 4. A question that may come to the mind at this principles like mean reversion, long termpoint is: How does all that scientific jazz relate investing and market efficiency have eitherto financial decision making? benefitted from such market movements or have been able to avoid major losses to theirWell, at BFM, we want our clients to be very investments.careful, patient, analytical and logical when itcomes to making important investmentdecisions.The recent times of economic slowdown andhighly volatile market activities have testedinvestors’ patience to a great extent. But amajority of those investors who believe inOur Advice We can point to some general practices that can help investors improve their investment decision making:  Thinking more analytically when making important financial decisions. Weigh your choices carefully!  Being pro-active, curious and non- assumptive at all times and spending time to evaluate investments, possible “In the short run, the market is a risks and benefits. voting machine. In the long run,  Continuously striving towards it’s a weighing machine.” – improving self-control and avoiding Benjamin Graham hastiness.  Avoiding making any important investment decision while being in a passive state of mind.  Creating a balance between being patient and being dynamic about investment choices. © 2011 Bourbon Financial Management, LLC. All Rights Reserved. +1 312 909 6539. 4