Wednesday, January 31, 2007

Market Psych in Money Mag

A brief bit of self-promotion. You can catch Market Psychology Consulting in the February 2007 issue of Money in Jean Chatzky's monthly column, "Money Talk". In her most recent column, titled Keep Cool in a Hot Market, she features some of Dr. Murtha's insights into avoiding retirement pitfalls -- of which there are many. (Note: Ambiguous modifying clause refers both to many pitfalls and many insights).

Thanks to Ms. Chatzky and Money for the mention.


Friday, January 26, 2007

Props to Behavioral Finance from Chairman Bernanke

I made a point of tuning in to watch the testimony of Fed Chairman, Ben Bernanke to the Senate Budget Committee on January 18. Why? Because I love watching senators who pretend to have a working knowledge of macro-economics attempt to ask "tough" questions of a man who clearly knows 500 times more about the subject. It reminds me of the conversations with my mechanic when I used to bring my old car in:

Me: So, what did you find out?

Mechanic: Looks like the needle valves in the carburetor got gummed up and its making a lean oxygen ratio in the float chamber. We'll have to change the plugs and patch the intake manifold. It'll take a couple days.

Me: Ah. I was afraid it might be the old Carbonator acting up.

Mechanic: Carburetor.

Me: Yeah, the Carburetor. That's.. uh, that's what I said.

To me it's the best part of the proceedings. But I experienced an unexpected delight when Mr. Bernanke single out the field of behavioral finance as being one of the most promising ways to address the long-term savings crisis.

He was asked what positive changes could be made in policy to help people's savings rates. He said that the most exciting options are coming from the psychological side of investing research. He referred specifically to the new "opt out" approach being taken by companies regarding their 401-K plans.

Tax free savings plans are a great idea, but they have always been optional. It used to be that employees were asked, "Do you want to take money out of your pay check to and put in the 401-K savings plan." A lower paycheck!?! Too many people said no.

But when the option was reframed to, "You're currently in our 401-K savings plan, would you like to opt out?" Again, most people said no.

The reason? Doing something requires an effort. Doing nothing does not. Physicists call this inertia. Behavioral Finance Consultants (such as Dr. Peterson and myself) call it The Status Quo Bias. The fact is, without a compelling reason we'd rather not generate the emotional energy necessary to make a change. The effect is so strong that most people who inherit a position will most likely make no change even when they admit that they never would have chosen that position for themselves!

Something as simple as applying the Status Quo Bias for savings plans does wonders for increasing the savings rates of employees. It was nice to see Chairman Bernanke credit the behavioral finance committee for its simple, yet revolutionary contribution.


Wednesday, January 03, 2007

Excited about a Good Deal

(or "Why value investors really are passionate people")

In a fascinating new neurofinance publication in the neuroscience journal Neuron ("Neural Predictors of Purchases", Professor Brian Knutson (Stanford) and economist colleagues at Carnegie Mellon (George Loewenstein) and MIT (Drazen Prelec) set out to discover the brain areas that drive purchases of consumer items. This is one of the pioneering studies in neuroeconomics.

In the experiments, Knutson showed experimental subjects a series of routine consumer products (such as a box of Godiva chocolates) and the prices at which they could buy those items from the researchers. The prices of the items had been discounted approximately 70% from their retail prices. The discount was necessary because subjects had been unwilling to buy the items near the full retail price.

Knutson found that activity in three brain regions predicted purchasing decisions. Activity in the Nucleuas Accumbens (NAcc) was associated with a preference for a product (a desire to possess it), and predicted that the participant would buy the item. The participants’ medial prefrontal cortex (MPFC) was activated when prices were very cheap, and its activation also predicted that the subjects would buy. Decreased activity in the brain’s pain center, the insula, occurred during this experiment, and this decreased activity also predicted buying. In conclusion, it appears there are three neural predictors of buying consumer items – desire for the product (Nacc), a cheap price for the product (MPFC), and low price (decreased anterior insula - fear and pain - activation).

There are several speculative applications of these findings to investment practitioners. The joy value investors feel when they find bargain-priced stocks may be due to MPFC activation. Value investors such as Warren Buffett, David Dreman, and Bill Miller may be driven by such reward-based motivations.

Stock investors who look for an exciting or desirable story may be buying stocks based on NAcc activation. Investors who see little risk in an investment are driven to buy by the absence of a perceived “downside” (decreased anterior insula activation). All of these brain functions are helpful for investors to identify excellent opportunities in the markets, and for the most part they appear adaptice and biologically-based.

By integrating these findings with what we already know about consumer behavior, neuroeconomists are developing a more coherent picture of what drives different types of financial decisions.