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Welcome to this lesson on emotions and decision making.
In this lesson,
we will learn that emotions constantly influence our decisions.
And that, just like the cognitive biases that we looked at in the previous lessons,
they can lead to irrational decisions when investing in the market.
For this, we will first explore how emotions
actually lead to financial decisions.
Then, we will take a look at the primary motives behind our investment decisions.
That is, why do we prefer investing in a stock market
instead of just putting our money in an almost risk free saving account?
We will learn how these motives translate into portfolio decisions.
And we will take a look at whether emotions are generally a bad thing
when making investment decisions.
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You may have already heard that risk preferences vary across generations.
That is, depending on when you were born, you may be more or
less risk adverse in your 30s or in your 40s.
The best known example for this are the so-called depression babies.
Depression babies are people who lived through the Great Depression or
were raised during the Great Depression.
And researchers have shown that these people indeed show a larger
risk-aversion later in life.
That is to say, the Great Depression had a long less lasting effect on the risk
preferences of these people.
Note that this effect is stronger the more recent the crisis.
For instance, right now we also experience that
people are more risk-averse following the 2008 financial crisis.
Now, there are several reasons that you can come with for why that is.
Why are people more risk-averse following a crisis?
So the first thing you might argue is, well, if somebody lost money in a crisis,
then they naturally have less money now.
And if you have less money you tend to be less risk-averse,
you just cannot afford to take risks.
The point is though, that this increase in risk-aversion doesn't just apply to
people who actually lost money.
It also applies to people of the same generation who didn't have any money
invested in the stock market at the time.
They too become more risk-averse as a consequence of the financial crisis.
That means the change in wealth cannot be the only explanation for
why you're suddenly more risk-averse.
So what else might be going on?
So you may say, well, if you've experienced financial loss or
you've seen a lot as of people experience financial loss,
you may be afraid to lose money again.
Or to lose money yourself when you enter the stock market.
Now this is an interesting statement because it says, you are afraid.
It basically indicates that the driving factor behind your preferences, or
behind your investment decisions, is fear, the fear of losing money.
So the decision of people to be more cautious isn't actually driven by
a careful analysis of the post-crisis market,
it is primarily driven by a strong emotion, fear.
The hypothesis that fear is behind an increased risk-aversion has been tested in
the lab as well.
Because you ask, well, is fear that is related to financial risk or
is this fear in general?
So, one experiment that researchers have done is, they've brought people into
the lab and they tried to illicit fear in them by showing them horror movies.
And following the presentation of the horror movies,
they assessed their risk preferences.
And it turns out that, indeed,
people are more risk-averse after having seen a horror movie.
That is, fear in itself, not necessarily fear related to financial investments,
induces a higher risk-aversion.
Now this indicates that this is really the underlying emotion, the fear that drives
your investment decision and not any rational considerations.
If you're still not convinced by this,
I can give you one more experiment that came out of neuroscience.
Researchers have tested people who have amygdala damage.
So, you may have heard of the amygdala,
a small region in the brain which is known to process stimuli related to fear.
And they are people whose amygdala is damaged, partially or completely.
Now, if you ask people with amygdala damage to make financial decisions their,
in principle, perfectly capable of making these decisions.
They can respond to expect a rewards.
They can respond to risk.
The one thing that is different in them is they don't seem to
have much loss aversions.
Something that is typically observed in the healthy population.
So by removing your fear center,
the amygdala, you're also losing your loss aversion.
University of Geneva- Michel GirardinLecturer in Macro-Finance - Project Leader for the "Investment Management" specialization
