Irrational decision-making is at the heart of our current economic downturn, say psychologists and economists alike. Americans bought homes they couldn't afford, banks handed out overly generous loans, and investors panicked when things looked grim.
Paul Zak, PhD, founder of the Center for Neuroeconomics Studies, has a few ideas on how these factors contributed to our ailing economy and what we can do to ride it out. The neurobiology-trained economics professor at Claremont Graduate University in California conducts research into how people's brain physiology affects their economic decisions. His new book, "Moral Markets: The Critical Role of Values in the Economy" (Princeton University Press, 2008), demonstrates how today's economy is driven by human quirks and insecurities.
From a neuroeconomic standpoint, how did we get into this mess?
Regarding the housing market crash, I think some of that was herd behavior. We're herd creatures. That's really useful for learning from each other, but it also has downsides. People were saying, "You have to be in the real estate market!" Even if they didn't have a lot of information, a lot of people thought that was the smart thing to do because of herd behavior. You often see that in bubbles. They survive as long as you have one more sucker. When you run out of those people, the whole thing collapses.
How do our minds react to highly unstable situations like these?
The classical view of economics is that decisions are made with a lot of thought and analysis. We know now that many of these decisions are driven by emotion. With buying decisions, we see over-activation in the "wanting" or reward areas of the brain.
Some recent work from Brian Knutson's lab at Stanford showed that when heterosexual men viewed pornographic pictures, it revved up their wanting/seeking system in the brain, which is associated with dopamine release. When they had to make financial decisions immediately afterward, they chose much riskier portfolios.
Something similar happened with the housing market.
Everyone was buying real estate and this dopamine system was in overdrive. Now that it's burst, the opposite has happened. We're in a highly uncertain, fearful environment. Studies have shown that brain areas that process risk are the same ones that process pain, so the brain's reaction to this fearful, uncertain environment is, "Get away!"
Just as we saw an overreaction when the market was trending strongly upward, I think we're also seeing an overreaction as the bubble is bursting. The brain has put you into survival mode.
You need to know that your brain is prone to overreaction.
Will an economic downturn affect our purchasing behaviors?
Certainly when we're highly emotionally engaged, there's some conflict with clearheaded decision-making. I've seen studies that say that, for example, when the stock market is down, people eat more at McDonald's. I'm not sure exactly how valid all of those are, but we do indeed have the ability to self-medicate.
For example, when people are stressed out, they tend to eat more carbohydrates, which are serotonin precursors, and serotonin damps down our stress levels a bit. So, it would be interesting to see whether if six months from now people's average weight has gone up because people have been pounding down pasta because they've been stressed out. Or maybe we'll see drinking going up. I can't say for sure what it will be, but there will be a desire for self-medication.
Why does the stock market swing so wildly during economic crises?
There's a saying in economics that the stock market has predicted 12 of the last eight recessions. The stock market is good at overreacting. The market is the aggregation of lots of individual decisions. When there's a lot of uncertainty, like there is in the stock market, it turns out that making decisions involving money generates strong activation in the areas of the brain associated with fear. In the market, you see the aggregation of all these stressed-out, fearful choices in which any little piece of news or rumor drives the market up or down.
Knowing that we're prone to overreacting, what can we do to make better decisions?
First of all, there's a good evolutionary reason for why our brains are prone to overreaction. If half your resources are wiped out in the African savannah, that's a highly stressful situation and you should definitely be in a high-alert mode. Our brains are just not well adapted for the kind of quick, high-volume news that we get now. If you feel like, "Oh my God, I need to get out the market now!" what you want to do is not make that decision right now. Wait a couple of days. Most people should just stick to what they were doing already.
The same dopamine system in the study involving men and pornographic pictures also activates when we get any kind of new news. One thing I suggest to professional brokers is not to watch TV, where you're going to get all this rumor and innuendo. Wait until the next morning and read the papers. Don't get sucked into the news cycle. You want to follow rules, so when your emotions say, "Get away, this is painful, flee to safety," you can use prefrontal control and think long-term. I think this is the time to reduce emotional conflict, take a break, dump all the news and stick with the investing rules you have been using. Because of dollar cost averaging, if you purchase a fixed dollar amount of stock each month when the market is down, you are getting more stock for your money. This will increase your long-run returns.