Goal approach refers to the motivational actions of the reward system, driving individuals toward achieving desired and expected goals. Feelings related to elation, such as happiness, joy, euphoria, and contentment are generated when goal approach progress exceeds one’s expectations. When goal approach is inadequate relative to one’s expectations, feelings related to disappointment such as sadness, upset, discomfort, and depression arise.

FIGURE 3.1 The brain’s comparator generates emotional experience based on the difference between one’s expectations and actual goal progress.

Source: Derived from Carver, C. S., and M. F. Scheier. 2001. “On the Structure of Behavioral Self-Regulation.” In M. Boekaerts, P. Pintrich, and M. Zeidner (eds.), Handbook of Self-Regulation. New York: Academic Press, pp. 42-80.

Goal avoidance refers to the function of the loss system, which motivates individuals to avoid or escape dangerous circumstances. When loss avoidance is successful, feelings of relief occur. Feelings of anxiety, worry, concern, and nervousness arise when one is not avoiding dangers as well as anticipated.

Supporting the model of the comparator, neuroimaging shows that expected financial rewards activate the reward system less when they are received. When goal progress is equal to expectations, then no emotional reaction occurs.¹ However, both unexpected rewards and unexpected news that one is going to receive a reward are highly activating, because they both exceed expectations of goal progress.²

Interestingly, when news of an impending reward is received, but the expected reward never comes, then the brain will show inhibited activity. Specifically, there is decreased dopaminergic neuronal firing in the reward circuits at the precise time when the expected reward should have occurred.³ Perhaps this is a neural representation of disappointment.

COUNTERFACTUAL COMPARISONS

Emotions often arise when one compares his or her life circumstances to those of others. Psychologists set up an experiment in which they clipped out the photos of Olympic medal winners’ faces during the award ceremony at the Olympic Games. Strangers were then asked to rate the level of positive or negative emotion on the faces of the medal winners, without knowing which medal they had won. The researchers found that, as expected, gold medal winners expressed the highest level of positive feeling. Surprisingly, bronze medal winners had the second-highest level of positive emotion, while silver medalists came in third.⁴ Why are silver medalists less happy than bronze medalists?

The Olympians were experiencing counterfactual comparisons. Bronze medalists make a downward comparison, due to a “cutoff effect,” and they felt happy that they had earned a place on the winners’ podium. Silver medalists made an upward comparison, and they felt slightly disappointed by what they saw—someone who performed better.

Counterfactual comparisons also affect how people feel about profits and losses. Professor Barbara Mellers at the University of California at Berkeley designed a gambling experiment to assess emotional reactions to losses (gains) if a larger loss (gain) had been avoided. Subjects were asked to play a 50-50 gamble. In one version, subjects would either win $8 or win $32 (each with 50 percent probability). In another gamble, subjects would either lose $8 or lose $32 dollars, again with 50 percent probability. The subjects had no choices to make, but they were asked to rate their feelings after seeing the results of the gamble.

Subjects reported feeling slightly positive when they lost $8 if they had avoided losing $32. When the subjects won $8, they reported slight dissatisfaction because the other outcome was to win $32. The subjects felt good about losing $8 if the gamble was in the “loss frame,” and they felt bad about winning $8 in the “gain frame.” Their comparison of the actual outcome to the gamble’s expected value (in this experiment the expected values were $20 in the gain frame and -$20 in the loss frame) determined how they felt about the outcome.

This comparison phenomenon occurs throughout the business world, where measures of self-esteem and accomplishment are often made tangible. Silicon Valley billionaires may feel jealous of the size of each others’ yachts, leading to a boom in the construction of ultra-luxury vessels as each tries to outdo the others. A nonbillionaire sailor may feel happy simply to be in the same marina as such beautiful boats.

Portfolio managers can also suffer from the comparison effect. When managers miss out on a market rally, then they can become disappointed that they are not achieving their expected performance and anxious about underperforming their benchmark (and their colleagues).

Sometimes the best-performing money managers are lauded with praise. Yet too often this praise is followed by underperformance. Why? Perhaps they lose the motivation that was driving them in the first place when they achieve their goals. When one measures success by comparing oneself to another (like the hare in Aesop’s fable of the tortoise and the hare), then winning the comparison makes one feel happy, but also deprives one of the motivation to continue working hard. If one is outperforming expectations, then why continue to work so hard? Success can thus be a performance trap if it is measured by comparison to others or other external benchmarks.

Alternatively, when success is measured according to an internal benchmark, such as an improved decision process or clearer judgment, then it remains an enduring motivation and leads to long-term excellence. Portfolio managers who focus on refining their decision process, stoking their curiosity, and developing a sound investment philosophy are more likely to be long-term outperformers. Chapter 22 discusses this issue in more detail.

Via the comparator, emotions arise when feedback about one’s expectations is received. The level of attachment to one’s expectations (ego involvement) determines the strength of his or her emotional responses to goal-related feedback. This explains the popularity of Zen- and Buddhistthemed books for traders and investors. Teaching detachment from the outcome, not the process, is the goal of these books.

Outcome comparisons arouse emotions. Detaching oneself from outcomes reduces one’s emotional arousal and emotion-driven judgment biases. People who practice Buddhist meditation may more easily perceive the quiet murmurs of intuition while calming the loud voices of excessive emotion. Unfortunately, because most investors are attached to the outcomes of their trading (e.g., because their bonuses depend on those outcomes), they are vulnerable to the influence of reactive emotions.

BELIEFS AND EXPECTATIONS: THE PLACEBO EFFECT

Sometimes expectations of successful goal progress create a self-fulfilling prophecy. A belief in one’s ability to achieve a goal activates inner resources to support goal pursuit. Such success beliefs prompt supportive neurochemical shifts, which enhance mental and physical endurance. The placebo effect is an important example of how one’s beliefs, desires, and expectations can align to change his or her state of being. When a physician gives a patient a medicine, it represents a belief that the patient will get better, which reinforces the patient’s internal motivation to regain health.

Irving Kirsch, a psychologist at the University of Connecticut, analyzed 19 clinical trials of antidepressants and concluded that the expectation of improvement, not adjustments in brain chemistry, accounted for 75 percent of the drugs’ effectiveness.⁵ “The critical factor,” says Kirsch, “is our beliefs about what’s going to happen to us. You don’t have to rely on drugs to see profound transformation.” Between 35 and 75 percent of patients benefit from taking an inactive sugar pill in studies of new drugs. For centuries, Western medicine consisted of almost nothing but the placebo effect.⁶

While the placebo effect can improve health based on a belief in a positive outcome, a nocebo effect is an ill effect caused by the suggestion or belief that something is harmful. In both the placebo and nocebo effects, the expectation of an outcome creates a self-fulfilling prophecy.

In the markets, participants’ expectations are rapidly priced in. Much of the art of investing is the ability to understand one’s own expectations, the market’s expectations, and the economic fundamentals. When the market’s expectations deviate from underlying fundamentals, an expectation-related emotional shock is more likely going forward. For example, when Internet stocks with high price-to-earnings (P/E) ratios climbed far beyond reasonable expectations for growth, pricing in the market’s overoptimistic expectations, it became clear that the differential between expectations and reality would eventually be narrowed as these stocks failed to keep up with investors’ lofty goals.

A stock’s P/E ratio generally reflects investors’ growth expectations. Ironically, stocks with low ratios (and low expectations of growth) often outperform those with high ratios over time. This is one tenet of value investing (see Chapter 23). One reason why value strategies work well is that investors’ low expectations are more frequently positively surprised, leading to increased positive emotion being associated with the low P/E stock, while high P/E stocks more often disappoint because the “good news” is already priced-in.

MAKING SENSE OF THE NEWS

Every day after the markets close, journalists interview traders looking for the reasons behind the day’s market action. The proffered explanations are typically concrete and logical. Market moods are often explained in a cause-and-effect relationship with recent events. For example, following the October 19, 1987, crash in world stock markets, the BBC attributed the market plunge to rational news-driven panic: “Trading activity was driven down by growing fears of rising interest rates and a falling dollar. These were exacerbated by the news that the US had retaliated against Iranian attacks in the Gulf by bombarding an offshore oil rig.”⁷

The BBC’s logic is faulty because it attributes the panic entirely to recent price action and world events. News and price changes do influence investors’ emotions, and there is a positive feedback effect from such events on how investors feel. Yet the depth of the panic did not reflect the intensity of the mildly negative news. Investors were already predisposed to panic on that October day.

In a post-note to the BBC article, the editors admit that, “The debate over the cause of the crash continued for many years after the event but economists have never been able to name a single factor that ushered in Black Monday.”⁸ In hindsight, the news-driven explanation for the crash was dismissed, and uncertainty was given its due.

Why does the BBC seek a single-factor explanation for the panic? Maybe because its readers are uncomfortable with uncertainty and the lack of control it implies. If you hear that investors panicked, you immediately want to know why they panicked. “Because they were afraid” isn’t a satisfying explanation. “Because they were overconfident” is also inadequate. “Because interest rates rose” fits into a neat mental model.

One deficiency of causal reasoning in market commentary lies in the direct attribution of investor emotion (such as fear and greed) to recent news events. Yet sometimes bad news doesn’t provoke fear or move the market, while other times it does. Why does some news cause fear at one time, but similar news provokes no reaction a few months later? How investors interpret news and events depends on their underlying emotional outlook. Optimistic investors see a sharp price plunge as an opportunity to “bargain shop” for cheap shares, while pessimists view it as evidence that the global financial system is collapsing.

Interestingly, there are periods of time when strongly negative news doesn’t impact an optimistic market, and times when positive news cannot revive a bear market. During these periods, investors are succumbing, on a group level, to emotional defense mechanisms. Emotional defense mechanisms are a form of self-deception that distort investors’ interpretations of news that contradicts their strongly held beliefs.

SELF-DECEPTION

While the media “rationalize” market events in hindsight, individual investors have their own emotional defenses and contortions of logic to contend with. Especially when under stress or when confronted with negative personal information, the brain has a tendency to cope by means of self-deception.

Emotional defense mechanisms are the process by which the mind minimizes the negative emotions that arise from an unfavorable comparison. Negative emotion can be attenuated through distorted logic (rationalization), avoidance (denial), believing an internal feeling is also being felt by another (projection), or blaming circumstances out of one’s control (externalization). In an example of projection, when investors feel uncertain about the market’s future direction, they often believe their own disorientation is a result of “market uncertainty.” More often than not, the source of the uncertainty is in the investors themselves. One example of externalization is retail traders blaming their market losses on “manipulators” rather than taking responsibility for them. Defense mechanisms operate unconsciously, yet they have a profound effect on the ability to perceive reality and develop accurate expectations.

A few biases discussed in this book result from emotional defense mechanisms. The hindsight bias, rooted in memory, involves excessively optimistic assessments of one’s past accomplishments, often fueling further misguided endeavors. The confirmation bias drives an active search for facts that support one’s opinions and beliefs, while contradictory information is ignored. The projection bias involves misjudgments about one’s future needs and desires, arising from one’s belief that one’s current emotional state is similar to what one will feel in the future.

EMOTIONAL DEFENSE MECHANISMS AND MOTIVATED REASONING

One defense mechanism, which is a type of rationalization, is called motivated reasoning. Motivated reasoning is thinking biased to produce preferred conclusions and support strongly held opinions.⁹ Like other defense mechanisms, motivated reasoning can be viewed as a form of emotion regulation, in which the brain moves one toward minimizing negative and maximizing positive emotional states. Motivated reasoning as a strategy for emotion regulation was first described by the Viennese neurologist and father of psychoanalytic psychiatry, Sigmund Freud, who observed that people can adjust their thought processes to avoid negative feelings such as anxiety and guilt.

Professor Ditto at the University of California at Irvine set up an experiment to investigate motivated reasoning. He videotaped participants as they self-administered a bogus medical test. The subjects were coached that one result color on the test strip was favorable, while the other was an unfavorable (but unnoticeable) diagnosis. Subjects who received the unfavorable diagnosis required more time to accept the validity of the test result, were more likely to spontaneously recheck it, and believed that the test had lower accuracy than those with the favorable results. ¹⁰ Not only do people underestimate the likelihood of negative feedback about themselves, but even after they are presented with it, they tend not to believe it (and actively argue against it)!

Researchers at Emory University studied motivated reasoning in politically active individuals before the 2004 U.S. presidential election. They presented contradictory statements from each candidate, George W. Bush and John Kerry, to subjects while they were observed in an fMRI scanner. After a short delay, the contradictory statements were then excused by an exculpatory statement provided by the experimenters.

Initially, when subjects were presented with their favored candidate’s contradictory statements, they demonstrated greater nucleus accumbens activation (an area associated with positive emotion and motivation in the reward system). The authors speculate that this activation occurred because “when confronted with information about their candidate that would logically lead them to an emotionally aversive conclusion, partisans arrived at an alternative [positive] conclusion.” The nucleus accumbens activation represented the emotion of relief as the threatening information was reconciled with their positive opinion of the candidate. The subjects were experiencing a positive emotional reaction to the resolution of tension. According to the authors, the nucleus accumbens activation may represent the subjects’ motivation to find excuses for obvious contradictions.¹¹ It’s pleasurable for them to resolve the contradiction, so they are motivated to do it.

Interestingly, in the Emory study, “Motivated reasoning was not associated with increased neural activity in regions previously linked to ‘cold’ reasoning.”¹² When using motivated reasoning, partisans are rewarded (with nucleus accumbens activation) by resolving the contradictory statements in their favor, and the brain regions associated with negative emotion (the insula and lateral orbital-frontal cortex) are quieted. ¹³ These results suggest that emotional defense mechanisms may be a neural process in which individuals are driven to find information or adopt beliefs that increase reward system activation (and reduce negative emotions).

People who engage in motivated reasoning perform more poorly on decision-making tasks than those who are less defensive about negative information. Researchers designed a card-sorting task where the fastest solutions were achieved by considering threatening information. “Participants who considered a Wason task rule that implied their own early death (Study 1) or the validity of a threatening stereotype (Study 2) vastly outperformed participants who considered nonthreatening or agreeable rules.” In conclusion, “A skeptical mindset may help people avoid confirmation bias . . . in everyday reasoning.”¹⁴ Actively confronting uncomfortable information led to superior decision making.

Courage is essential when facing uncomfortable negative emotions. During a bear market it is easy to think about the economy pessimistically—everyone is doing it. The goal in such a situation is to look for the positive aspects of the economy—the ones that are being overlooked. This requires balanced thinking, courage, and a willingness to look at all available information with equanimity. George Soros indicated that one of the keys to his acumen is the ability to nonjudgmentally think about why his investment reasoning process may be wrong (his theory of fallibility).

Understanding the effects of expectations, counterfactual comparisons, and emotional defenses on decision making is the first step toward improving performance. The next chapter will move back to a micro-level focus on the neurochemical origins of financial decision making.