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June 18, 2010

Emotion & Money

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  Risk Glossary

The Emotional Brain

Science Museum: Emotions and Your Brain

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Could the fear of losing money keep you from making money? Scientists studying investment behaviors say emotions may be what's behind the average person's failure to master the market. This ScienCentral News video explains.

Taking Risks

Stock market traders are trained to keep a cool head where money is concerned. But what about the rest of us?

"I think the people who you see trading on the floor of the exchanges have so much experience that they probably, to a great extent, not completely but to a great extent, learn to control their emotions or work with their emotions," says economist George Loewenstein, from Carnegie Mellon University. "It's the individual investors that are often led astray by their emotions."

Loewenstein and his research team have been studying the role of emotion in decision-making.

"My collaborators and I are very interested in the role of immediate emotions in human behavior, the idea that people's behavior is determined, not by an assessment of the consequences of decisions, but simply by the immediate emotions that they're experiencing," he explains. "Emotions are clearly very important for human functioning, and people who have damage to emotional parts of the brain exhibit all sorts of different problems. But emotions also have a downside… they can lead people to be very aggressive, they can lead people to be very impatient."

In particular, Loewenstein's group is interested in whether it is possible that people with damage to the emotion parts of the brain might make better decisions, economically more advantageous decisions, than normal people in certain circumstances. Research has shown that normal people tend to be pathologically risk averse.

Stroke brain injury.
image: George Loewenstein, Carnegie Mellon University
As reported in Discover magazine, the team found that fear and investing don't mix. They found that stroke victims and others with damage to the emotional centers of their brains make better investment decisions than those with a full range of emotions.

"These were stroke patients, but also patients with various types of organic brain damage caused by disease and also from brain surgery," he explains. "We specifically sought out patients with damage to emotional areas of the brain." They also compared these groups to a control group of patients with brain injuries in other parts of the brain, and specifically to parts of the brain that are more associated with mathematical calculation and various types of analytical operations, to show that any results were not just a result of any brain damage.

The researchers used a simple coin-toss gamble to study the investing performance of people whose emotions have been altered by stroke damage, compared to people with their full range of emotions intact.

Loewenstein gave participants $20 and conducted 20 coin flips. Before each flip, they could keep a dollar or invest it: heads, they lose the dollar; tails they win $2.50. Given the 50-50 odds of a coin toss, a volunteer would on average pocket $25 by gambling every time but end up with only their original $20 if they never take the plunge — a situation where investing has a clear advantage.

"It's much better than you would get if you go to Las Vegas. It's better than you're going to get on Wall Street," he says. "But people are really deterred by losing the dollar."

Healthy volunteers, whose emotions were intact, invested only 58 percent of the time, while patients with damage to their brain's emotional centers invested in 84 percent of the coin tosses. As a result they make more money.

"When we looked more carefully at the behavior of both the normal subjects and the control group with lesions to non-emotional parts of the brain, what we found was they started out investing at a fairly high rate and then they, over time, they tended to decrease their rate of investing," explains Loewenstein. "And when we looked more carefully at the data, what we found was that when they invested and they lost the money, they would get discouraged, and they'd get afraid for the future, and they would stop investing in the future, whereas the patients with the damage to the emotional parts of the brain were simply not deterred by losing money in the investment task."

Loewenstein says the healthy people may have felt safer with the money in hand, a feeling that overruled their logical thinking, adding that acting on emotions is what separates most of us from the pros. But he thinks we can train ourselves to separate fear from finances.

"If you get an email that, you know, sets you off, the best thing to do is to wait a day before you respond to it. The same is true in the market, that if you have a sudden urge to do something, wait a day and see if you still have the same urge a day later or maybe a week later, and then if you still want to do it maybe it's a good idea," he says.

Next, Loewenstein plans to look at how emotion impacts savings behavior.

Loewensteing's work was published in the June, 2005 issue of the journal Psychological Science, and was funded the National Institutes of Health and the National Science Foundation.

       email to a friend by Lindsay Carswell

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