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Investor Emotions: How They Rule Decision Making

Friday, 22 Jun 2012 | 2:14 PM ET

Wild market swings in recent years have investors running for cover and even the exits.

NYSE trader
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NYSE trader

On any given day, we’re bombarded by headlines about the euro-zone crisis, gridlock in Washington, DC and conflicting reports on the health of the American economy and U.S. corporate profits.

It’s enough to make your head spin and your gut churn.

But which part of your body should you listen to when you’re trying to make sense of it all and decide on a particular investment strategy?

Derivatives trader-turned-Cambridge neuroscientist John Coates says both. "Anyone on Wall Street knows if they are taking financial risks—making and losing lots of money—their bodies are profoundly affected."

He’s now taken what he learned on Wall Street and applied it to the study of financial risk-taking. In his new book, “The Hour Between Dog and Wolf: Risk Taking, Gut Feelings, and the Biology of Boom and Bust,” Coates points out that periods of extreme stress or rushes of adrenaline can overpower the purported black and white world of finance.

"Sometimes [our bodies] can overreact. During winning streaks, for example, you can become irrationally exuberant. During losing streaks, you can become irrationally risk adverse,” he said on CNBC’s “Street Signs.”

In 1996, then-Federal Reserve Chairman Alan Greenspan famously used the phrase “irrational exuberance” when describing stocks during what we now know was the dotcom bubble.

Coates believes it’s the job of the risk-managers on Wall Street to recognize this type of dangerous euphoria. "People on winning streaks are prone to lose the most amounts of money,” he said. “Maybe they should [be pulled] off the field for a while."

Case in point: JPMorgan’smulti-billion lesson in failed risk-management that landed CEO Jamie Dimon in the hot-seat twice on Capitol Hill. Meanwhile, shares of JPMorgan have fallen about 17 percent since the so-called London Whale trades were disclosed.

Biology Behind Risk-Taking?
John Coates, University of Cambridge research fellow, discusses the evolution of traders and investors over the last few years, and whether traders are becoming more fearful and less daring.

Rational and logical decision-making have been at the cornerstone of economic theory—the belief that people always weigh the pros and the cons and act in their own best interest.

But for the grey areas, behavioral economists and scientists like Coates say it’s impossible to treat investing as a purely intellectual exercise. They contend that mind and body work together to influence decision-making and sometimes they are at odds.

The recent Facebook IPO certainly pointed out how investors can get caught up in the hype of a stock, and just as easily bail when sentiment turns.

A new study by research firm, TABB Group, says the botched Facebook public offeringhas had almost as much of a knock on investor psychology as the flash crash of two years ago.

The 2010 flash crash happened just about a year after the Dow hit 12-year lows in the midst of the financial crisis. Since then, the Dow has nearly doubled to 12,573.57 as of Thursday’s close despite a drop of 250 points during Thursday’s trading session.

Coates says investors often respond to feelings of “missing out” on market moves or feelings of panic, which can lead people to get in at the top or get out at the bottom.

But in this world of triple digit moves up and down on a weekly or even daily basis, indecision still rules the day on Wall Street. The latest sentiment survey from the American Association of Individual Investors splits pretty much evenly with about 33 percent of respondents in the bull camp, 31 percent neutral, and nearly 36 percent bearish.

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