Emotions count: The brain chemistry behind investing

When scientists at Caltech studied the brains of traders who successfully maneuvered through a market bubble, they found markers of two different traits.

One was something along the lines of anxiety. Successful traders, defined as those who sold before the bubble popped in a lab, sensed in themselves an unease stemming from the perception of uncertainty. They had higher-than-normal activity in an area of the brain known as the insula, which keeps track of how the body is feeling, said Colin Camerer, behavioral finance and economics professor at the California Institute of Technology. It's known to be activated by financial risk.

Brain
Oliver Burston | Ikon Images | Getty Images

Those who weren't as successful at investing and seemed to be chasing returns had a reduction in activity in the insula, "as if their brains think the price is following a very regular low-risk growth path," said Camerer in an email to CNBC.

The conclusions are just the latest insight from the emerging field of neuroeconomics. Over the past few decades, behavioral economics has led many experts to talk about the destructive effect of emotion on investor behavior. The picture that is emerging from neuroeconomics, which relies not only on observations of behavior but also brain scans, is more complicated.

At Caltech, researchers discovered that it wasn't only the activity in the insula that set the successful traders apart, it was their ability to act on the information in opposition to what everyone else was doing. In fact, there was another group that felt the unease but didn't act on it. They are people who would tend to say, 'I felt something wrong in my gut but didn't act on it.' The experiment looked at the way approximately 20 traders dealt with a risky asset over 50 trading periods.

People who are good at emotional regulation—in other words, overcoming their unease at going against the herd—tend to be better at investing, said Camelia M. Kuhnen, associate professor of finance at the University of North Carolina's Kenan-Flagler Business School.

If you're the kind of person who could go skydiving or who could talk yourself out of an action, like selling in a panic, you might be good at emotional regulation. You might say to yourself, "I know there is no day-to-day predictability in the market. I know this objectively, and even though I feel this sense of anxiety, what I saw in the market yesterday doesn't mean I should sell," Kuhnen said.

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But emotional regulation isn't all you need.

"It turns out you have to have an understanding of other people's emotions," said Kuhnen.

Other research has shown that good investors also have a strong theory of mind. This is the capacity that develops at around age 2 or 3 in children that enables them to understand that people around them are different and to guess what their actions might be. It's aligned with empathy but not the same, said Kuhnen.

What's your risk IQ?

The conclusions make sense if you consider that while the market is unpredictable, it may not be random, constructed as it is from billions of actions of investors.

If you are considering becoming a DIY investor, it may be worthwhile to consider whether your personality traits will hurt or help you along in that goal—and how hard you're willing to work on your capacity for making good investing decisions. Here are some tips, culled from neuroeconomics research.

Know thyself: How aware are you of your own feelings and the situations that prompt them? If you track your feelings in response to the market's movements, you'll be able to use them as an indicator. "Many of the world's best investors have mastered the art of treating their own feelings as reverse indicators. Excitement becomes a cue that it's time to consider selling, while fear tells them that it may be time to buy," writes Jason Zweig in "Your Money & Your Brain," a recent book about neuroeconomics.

The more you practice being aware of your emotions, the more you are able to regulate them, suggested Kuhnen, who noted research that shows that experienced traders have fewer of the physiological hallmarks of fear in response to unusual events, like sweaty palms and a fast-beating heart.

You can also investigate your own theory of mind or take a test that looks at how well you read people's emotions.


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Build a support system to help you act against the herd. Some people are natural renegades and may even identify themselves that way. But most of us look to our peers and social supports to help decide what actions to take. If you want to build your capacity to go against the herd, consult with people who have a proven capacity for acting independently. You can also write down a record of your own (presumably well-researched) opinions, so that you can see if you are changing your opinions to conform to the crowd. If so, think again.

Read More3 reasons YOU could be your money's worst enemy

Be aware of your environment while making investing decisions. Khunen's research showed that when people are excited, they tend to act on it. "If they are in this exuberant state, they would take more risk," she said. "If they're at a casino in Vegas ... it's the free food and free drinks. These are the cues that trigger rewards."

She's also looked at neuroticism. If you tend toward that trait in your family, DIY investing may not be for you. Her research found that people with the gene linked to being neurotic invested less in equities and were less engaged in actively making investment decisions.