The Biology of Investing

John R. Nofsinger, Corey A. Shank

• Publisher: Routledge
• Year: 2020
• ISBN:
  9781000050202
• Edition: 1
• Topic: Commerce
• Subtopic: Investissements et valeurs mobilières

Why do people's financial and economic preferences vary so widely? 'Nurture' variables such as socioeconomic factors partially explain these differences, but scientists have been discovering that 'nature' also plays an important role. This is the first book to bring together these scientific insights for a holistic view of the role of human biology in financial decision-making.

Geneticists are now examining which genetic markers are associated with financial and economic preferences. Neuroscientists are now determining where in the brain financial decisions are made and how that varies between people. Endocrinologists relate the level of different hormones circulating in the body to financial risk-taking. Researchers are exploring how physiology and environmental conditions influence investment decisions, and how three types of cognitive ability play essential roles in investment success. This exciting and relevant work being done in these academic silos has generally not been transmitted among the scientific areas, or to industry. For the first time, this book integrates all these areas, explaining the myriad ways in which a person's biology influences their investing decisions.

Financial analysts, advisors, market participants, and upper-level undergraduate and postgraduate students of behavioral finance, behavioral economics, and investing will find this book invaluable, enabling a deeper understanding of investors' decision-making processes.

To further ensure this new material is accessible to students, PowerPoint slides are available online for instructors' use.

1 Biology and Psychology in Finance

The evolution of financial theory has moved at a blistering pace in the past few decades. The traditional standard finance approach is based on classical decision theory, which assumes that people and markets are completely rational. The underlying assumptions are that people have access to perfect information, which is costless the moment it is released, can apply unlimited brain processing resources, have internally consistent preferences, and use expected utility theory to maximize the benefits of the decision. In other words, when money is involved, people make unbiased decisions to maximize their own self-interest, and everyone should come to the same conclusions about risk and return. Furthermore, any error a person makes is not predictable and not correlated with other investors’ decisions so that market prices are not impacted. Unfortunately, these assumptions are not valid as people frequently make predictable irrational decisions, especially when money is involved. In fact, even Alfred Marshall, the economist who developed the supply and demand curves, recognized that people are affected by physiological influences when he said, “Economics is a branch of biology broadly interpreted.”

Standard finance theory has been challenged by behavioral finance as decades of research have shown that people do not meet the rationality benchmark of standard finance. Indeed, people frequently make the same predictable errors that others are making.¹ The ideal of the rational investor has been replaced with that of the normal investor.² While standard finance dictates how investors should behave when making financial and economic decisions to maximize their wealth, behavioral finance describes how they actually behave. Behavioral finance tries to explain actual behavior through psychological, cognitive, and emotional factors that often lead a person to biased, non-rational, financial decisions. As such, behavioral finance and behavioral economics have become mainstream financial paradigms. Some of the early pioneers in behavioral finance have received the Nobel Memorial Prize in Economic Sciences. They include Daniel Kahneman and Vernon L. Smith in 2002, Robert J. Shiller in 2013, and Richard Thaler in 2017.

When people make consistent errors, psychologists call them cognitive biases. One common cognitive bias is the bandwagon effect (also known as groupthink or herd behavior), whereby people tend to believe in things or ideas simply because the vast majority of others do. Similarly, consider the endowment effect, which is the tendency for people to put a higher value on objects that they own compared to a similar object that someone else owns. One aspect of the endowment effect is the IKEA effect, whereby people place a higher value on items, such as furniture, that they assembled themselves.

Behavioral finance calls these cognitive biases investment biases when describing investors’ decisions about their investments. For example, the literature consistently shows that investors who commit these investment biases earn lower returns compared to those who do not. However, if investors were rational, they would not make these financial decisions. As such, behavioral finance describes investors’ decision making much better than the standard finance ideal over recent decades. Furthermore, there is a good deal of variation in the decisions which people make that has not been explained. Why do some people succumb to a particular investment bias while others do not? Why does one investor make different decisions at two different times when faced with the same situation? Although behavioral finance has worked hard to discover these investment biases, it has been silent about the sources of the biases. What is the source of some people using an analytical mode of thinking while others are driven to use an intuitive approach? Behavioral finance describes people as being loss averse, but what drives some people to be more loss averse than others? One answer is described in this book – biology.

Biology can influence behavior in a transient, quasi-permanent, and permanent manner. Temporary impacts on decision making include the biological ramifications that are transitory, such as sleep deprivation, circulating hormone levels (such as testosterone), emotions, moods, or the environment (such as the weather). For example, people are likely to make a different financial decision when they are sleep deprived compared to when they are well rested. Tired investors are temporarily more risk and loss averse. Health status also impacts financial decision making as people in poor health tend to take less risk than healthy people. However, people tend to stay healthy or unhealthy for long periods of time, and these factors do not fluctuate as do sleep deprivation or mood. Thus, the physical and mental health status of a person tends to be quasi-permanent and can bias economic choices for many years. Finally, many biological influences are permanent. A person’s genetic code (i.e., their DNA or gender) might make them more likely to succumb to a specific bias, yet this genetic code cannot be changed.

The remainder of this chapter sets up the biology topics of the book. The topics are divided into three sectional themes: nature versus nurture; physiology; and cognitive outcomes.

Nature versus Nurture

To what degree are human behaviors innate versus learned? Is a newborn baby’s psychology a blank slate, or is the child partially pre-programmed from inherited DNA? Are decisions programmed by genome characteristics, or do they stem from a history of experiences? These questions have been studied for centuries. Physical traits such as eye color are determined by specific genes (i.e., nature). Some behavioral characteristics such as temperament may be more influenced by a person’s experiences when growing up, (i.e., nurture). More recently, the nature versus nurture debate has included financial risk aversion and investment decision making.

One interesting group of studies examines the behavior of twins. How do different types of twins invest? Note that identical twins share all of their DNA, while fraternal twins share about half of that DNA. Using a large sample of twin financial decisions, researchers can allocate the sources driving the decisions among genes (nature), rearing environment (nurture), and unique adult experiences. Another line of research uses this same idea but uses the decisions of adopted children, biological children, and biological parents. Twin and adoptee studies use birth status as a proxy for genetics. Can we examine a person’s genome directly? Yes we can. However, the vast number of genetic variations creates some analysis problems. Finally, there is one obvious chromosome difference that can easily be identified: males and females. There is a plethora of research on the differences in financial decisions made by men and women. However, there are often significant social norms about male and female behavior that can drive a person’s decisions. In the end, it appears that behavior is influenced by both nature and nurture. Still, the degree to which source has the greatest influence continues to be studied.

What Can We Learn from the Financial Decisions of Twins?

Chapter 2 reviews the studies and findings of the financial decisions of twins. Twin siblings share some portion of DNA and most are raised together. A striking result is that genetically identical twins make many more similar decisions than do fraternal twins. Examples of financial decisions include their preferences for saving, houses, financial risk taking, behavioral biases, and charitable giving. The propensity toward making a specific decision can be portioned between nature (genetics), nurture (shared rearing experience), and unique adult experiences. Depending on the specific decision, nature (i.e., genetics) is found to explain one-fifth to one-half of the variation in preferences between twins. A person’s unique experiences explain the largest variation in decision making. The nurture environment in which the twins were raised appears to drive a surprisingly small portion of these decisions. However, the nurture environment has a more significant impact on decisions made by younger adults. The ability for nurture to drive financial decisions declines as a person ages while the contribution of unique experiences rises over time, and the influence of genetic coding persists throughout life.

Investment of Adoptees and the Human Genome

Chapter 3 expands the research line of studying genetics in twin behavior by exploring the financial preferences of adoptees, their parents (biological and adoptive), and adoptive siblings (the biological children of the adoptee’s new parents). Adoptees share none of the genetic markers with their adoptive siblings, yet they share a similar nurture (rearing) environment. These studies report that biology plays an essential role in explaining economic and financial outcomes. They report that the nature contribution is about half of the post-birth effects’ contribution (i.e., nurture and unique experiences combined for about two-thirds). Thus, genetics explains about one-third of the variation of economic outcomes among people. The studies also report that there is a role model aspect of nurture. Specifically, the economic outcomes of mothers have more influence on the outcomes of daughters, while the outcomes of fathers have more influence on sons.

Adoptee and twin behavior studies use birth status to proxy for genetic coding. Now that the human genome has been mapped, people are exploring their DNA to learn about their cultural history and health vulnerabilities. However, assigning specific genetic markers to behavior is proving to be complicated. The problem is the vast number of genetic markers that differ among people. Trying to locate specific markers that drive financial behavior among the millions of genetic differences using samples of people in the thousands, even hundreds of thousands, often leads to spurious (untrue) results. Nevertheless, social scientists are developing methods to reduce the complexity by grouping the DNA differences among people. A person’s specific DNA combination of associated groups is called their polygenic score. Through this method, scientists have discovered the groups of markers associated with educational attainment. That same grouping influences economic outcomes and investment characteristics, like risk aversion, stock market participation, and probabilistic thinking. The polygenic score is the first step in determining the mechanisms for how genetic markers may influence financial decisions.

Do Men and Women Invest Differently?

Popular culture is full of expressions that indicate different expectations, biases, and behaviors between men and women. Some examples are “man up” and “throw like a girl.” Assertive men are often considered leaders, while assertive women are labeled bossy. Or consider John Grey’s book title Men Are from Mars, Women Are from Venus.³ Phrases like these express social norms or perceptions about the behavior and actions of men and women, whether real or not. Of concern here is whether there are any real differences in financial decisions. If differences exist, are they due to biology (sex) or to social norms (gender)? Chapter 4 first reviews the literature and concludes that men and women exhibit significant differences in financial decisions. Most importantly, there is strong evidence that women take less risk than men, including financial risk. Men tend to exhibit more overconfidence and are more likely to exhibit sensation-seeking behavior which may be causing this risk-taking behavior. Complicating the matter is that differences in financial behavior could be caused by differences in emotional reaction, competitive behavior, or financial literacy. Further exploration illustrates that social norms play an important role in shaping a person’s risk preferences. Overall, it appears that some differences between men and women are a detriment to women, while others are beneficial.

Physiology

Human physiology is the biochemical, physical, and mechanical function of the human body. This includes how the brain functions, the level of biochemicals like circulating hormones, and the body’s health. Psychologists have been studying how various aspects of physiology impact behavior. It is not likely a surprise that a traumatic brain injury may cause a person to exhibit poor judgment and impulsive behavior. However, even small variations in the function of healthy brains have an impact on behavior. One way the brain stays healthy is to regenerate during sleep. Thus, a significant lack of sleep affects the brain’s functions and increases negative emotions like fatigue, anxiety, and depression. As such, a tired person makes different decisions than when well rested. Finally, health also influences a person’s behavior. Furthermore, sick or unhealthy people have different economic and risk preferences than healthy people who have good diets and who exercise.

How various aspects of physiology impact financial decisions and investment preferences are explored in the physiology section of the book. For organizational purposes, physiology topics are centered on brain function, hormones, sleep, and wellness.

Brain Function and Financial Decisions

Everybody’s brain functions a little differently. The study of the structure and function of the brain during financial and economic decision making is called neuroeconomics. Using instruments like functional magnetic resonance imaging (fMRI) machines, researchers can map the location in the brain that activates when making different decisions. Activities mapped to the frontal lobe show more rational, controlled processes. Conversely, the amygdala activates during emotional and fear responses and is linked to irrational and impulsive decisions. Chapter 5 reviews the literature that compares the location of brain activation and the quality of financial decisions. People who use their amygdala during financial decisions are more likely to make irrational decisions, such as avoiding ambiguous choices and succumbing to loss aversion. Also, risk-reward decisions are mediated by the nucleus accumbens, which is part of the dopaminergic pathway. Finally, genetic variations seem to drive how the brain processes dopamine and serotonin. The presence of these neurotransmitters impacts the amount of financial risk a person takes.

The Influence of Hormones on Financial Risk Taking

Testosterone boosts aggression, competitiveness, and self-esteem, and is known as the male hormone because men have higher levels than women due to biological differences. Additionally, cortisol is known as the stress hormone because it appears in higher levels during periods of high stress. These hormones directly influence the chemical makeup of the brain by altering how neurons send and receive signals. Chapter 6 illustrates how hormones impact financial risk taking. Hormone levels can affect the brain at two different times. First, the amount of testosterone in utero influences the baby’s brain and body formation, which influence behavior through adulthood. Second, the level of hormones circulating in the body during the time of a decision affects the decision. Both circulating levels of testosterone and proxies for testosterone in utero are shown to be positively related to risk taking in economic and financial decisions. In addition, cortisol is related to risk aversion in economic and financial situations. Interestingly, higher levels of both testosterone and cortisol are related to irrational financial decisions.

Sleep, Coffee, and Investing

Sleep deprivation impairs everything a person might do, from physical activity to complex decision making. Poor sleep quality directly influences brain functions through decreased activation and neural function. Chapter 7 illustrates that people who are sleep deprived are both risk averse and loss averse. That is, they beco...