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How Investment Decisions Are Influenced By Our Genetics

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Dr Richard Peterson, Investment Decisions

With Dr. Richard Peterson, Expert on Investor Psychology and Investment Decisions, Author of Inside the Investor’s Brain: The Power of Mind Over Money

Steve’s guest, Dr. Richard Peterson, is a behavioral economist, a psychiatrist, and an expert on the psychology of financial decision-making.  His book, Inside the Investor’s Brain: The Power of Mind Over Money, offers unique insights into how the brain makes stock-trading decisions and how investors can develop emotional awareness for long-term investing success.

Emotional Priming

Steve starts by asking Dr. Richard Peterson to address what goes on in the minds of investors when markets drop.  Although investors rationalize market drops by linking them to profit-taking or the mechanics of the markets, Dr. Peterson believes the fundamental reason behind market declines is “emotional priming”, such as when news headlines create an unconscious reaction that leads us to take less risk than we otherwise would.

The headlines we read change how our brains function, with our blood flow and metabolism literally shifting from areas focused on opportunity and positive risk-taking to suddenly worrying about dangers and threats— literally making us more conservative and more risk-averse.

He sees this as a combination of nature (our genetic DNA) and nurture (the influence of our surroundings).

For instance, someone who grew up during the Great Depression might see stocks as much riskier than people who grew up in the boom of the 80s.

Epigenetics

In the context of growing up during boom or bust economic times, Dr. Peterson cites epigenetics, a field of study about how the life we live impacts our future generations through changes in our DNA.  Epigenetics suggests a generational transmission of adaptive characteristics such as risk aversion and influences investor behavior.

The Pain Of Loss

Steve points to the pain of loss being two times greater than the pleasure of gain, so down markets tend to elicit much greater fear and emotional reaction than up markets.

Dr. Peterson adds that the 2:1 ratio Steve quoted could, in extreme cases, be significantly higher for extremely risk-averse investors, for whom even U.S. Treasury bonds are too risky. On the flip side, pathological gamblers always look for risks, even when they know the odds are stacked against them.

What compounds the pain of loss is that bear markets are much steeper and more dramatic than bull markets. Bull markets rise like escalators, but bear markets fall like elevators.

Asymmetrical Bias

Steve likens this to an asymmetrical bias where a very small probability event, such as an air crash, drives an outsized reaction. For instance, over 30,000 people die of the flu every year, but when just one person died in the United States from Ebola, a lot of people were really worried.

Market Psych

Binding his background in psychiatry and finance, Dr. Peterson’s company, MarketPsych, focuses on actionable intelligence based on investor psychology.  His company monitors news and social media, analyzes data, and develops tradable indexes. For example, from 1998 to the present, MarketPsych gauged how bullish or bearish people were about Apple stock based on investor’s social media reactions to factors such as company news, its fundamental strengths, and whether people trusted the management team.

For instance, if a piece of news is played up, it could cause an overreaction in the market and offer up a trading opportunity—such as the temporary drop in airline stocks on Ebola fears.

The Madness Of Crowds

Dr. Peterson quotes Charles Mackay, the author of Extraordinary Popular Delusions and the Madness of Crowds, who said: “we find that whole communities suddenly fix their minds upon one object and go mad in its pursuit”, bringing phenomena like the current Bitcoin craze to mind.

Steve adds that phenomena such as “catastrophization” lead people to believe the worst case is more likely than it actually is and “herding” causes overreactions in the market.

Clearly, our DNA and survival instincts cause us to react in ways that do more harm to our finances, so consider reading Dr. Richard Peterson’s book, Inside the Investor’s Brain: The Power of Mind Over Money, to develop emotional awareness for long-term investing success.


Disclosure: The opinions expressed are those of the interviewee and not necessarily United Capital.  Interviewee is not a representative of United Capital. Investing involves risk and investors should carefully consider their own investment objectives and never rely on any single chart, graph or marketing piece to make decisions.  Content provided is intended for informational purposes only, is not a recommendation to buy or sell any securities, and should not be considered tax, legal, investment advice. Please contact your tax, legal, financial professional with questions about your specific needs and circumstances.  The information contained herein was obtained from sources believed to be reliable, however their accuracy and completeness cannot be guaranteed. All data are driven from publicly available information and has not been independently verified by United Capital.

Read The Entire Transcript Here

Steve Pomeranz: In the last few weeks we have had quite a violent decline in stock prices, which has many people worrying about the future of their financial security. And for those watching the markets closely, this extreme volatility can be quite upsetting. So I started thinking about how we as a human species process information.

Basically, what is the reality of a given situation? And what is our fear or our anxiety truly based upon? And really are they the same? So to discuss this, and other important human tendencies, I’ve invited a very distinguished guest. His name is Dr. Richard Peterson and he works as he says at the intersection of investor psychology and financial markets.

His financial psychology research has been published in leading academic journals, textbooks, and one of his books published in 2007 is Inside the Investor’s Brain. And I wanna welcome him heartily to the show, Dr. Peterson, thanks for joining me today.

Dr. Richard Peterson: Thanks for having me, Steve.

Steve Pomeranz: Today, fear has become the order of the day.

What is really going on? And how do these stories affect our actions and emotions?

Dr. Richard Peterson: Great question, Steve. And most of the time when we look at those market declines like we’re experiencing now, we tend to think of them as being a result of profit taking. Or the mechanics of the markets, the selling, the we’ve had a big rally, it’s time for markets to drop now.

But actually there are more fundamental and deeper reasons for these declines. And one of those reasons, especially that we see triggered by the news, is due what’s called emotional priming. Emotional priming is when the headlines create an unconscious reaction in us that leads us to take less risk than we would otherwise do.

And because it’s unconscious we tend not to notice it, of course, and we also tend not to believe it [LAUGH] when it’s quoted. But technically the process is called emotional priming.

Steve Pomeranz: Where does the word priming come into that term? I don’t really understand emotional priming.

Dr. Richard Peterson: Well it’s sort of like priming the pump.

Steve Pomeranz: Okay.

Dr. Richard Peterson: What’s happening is we are reading headlines that change how our brain functions. Our blood flow and our metabolism literally shifts from areas focused on opportunity and positive risks that we can take. To suddenly worrying about the dangers and the threats that are in our world.

So literally, how our brain is emphasizing its interactions with the world changes to become more conservative and more risk averse.

Steve Pomeranz: Is this something that is different from individual to individual based upon the environment or the upbringing that they experienced during their lives? Or is any part of this inbred with us genetically?

Dr. Richard Peterson: That’s a great question. It’s a combination, of course, of nature and nurture. The majority of the effect actually appears to be genetic.

Steve Pomeranz: Really?

Dr. Richard Peterson: Yeah, how we respond to risk or risk opportunities or a threat is largely determined by our genes. Although I say that with a caveat, which is we’ve identified a couple genes that are related to this.

And each of those independent genes may affect 30% of risk taking.

Steve Pomeranz: Okay.

Dr. Richard Peterson: We can’t explain more than say half of somebody’s risk taking and there’s many other factors. There’s things like the era that you grew up in. If you grew up in the Great Depression or after the financial crisis, you’re age of 20 to 24 or so, around that time.

You probably see stocks as much more risky than people who grew up in the boom of the 80s or in the 1960s, for example.

Steve Pomeranz: I think to some degree those that suffered greatly in the Depression, the offspring of those individuals also have some propensity or some feelings towards fear.

As a matter of fact, when I was very young and we were brought up in a culture of no money whatsoever. Or savings was a savings bank, maybe a Christmas club was as far as we got to thinking [LAUGH] long term. And when I would ask about stocks, my father would say well, people jump out of windows.

And this is all I knew until I actually got into the business. And I realized, well, I guess I’d better start reading some [LAUGH] stuff here because that can’t be it. But that was my point of view because that was my family’s point of view because they suffered so much during the Great Depression.

I guess I have a question. Do you think that upbringing somehow permeates into our genetic codes in some way?

Dr. Richard Peterson: That’s a great question. In fact there’s a field of study about how our life development tends to impact ourselves and then future generations [LAUGH] as well through changes in our DNA.

And it’s called epigen genetics, epigenetics. The challenge with epigenetics is we know that there are some effects where the experience that your parents have literally changes their genes. And those will be passed on to you with a slight modification. Often it’s not changes of the genes, it’s changes of the environment around the genes, it’s quite complex.

But what’s interesting about this is, yes, there do appear to be generational transmission of adaptive characteristics. Now beyond just the pure DNA explanation of evolution, but this is a whole other discussion, really. I guess what’s really relevant to your audience is that yes, there are both sort of cultural transmission of ideas.

But there’s also potentially genetic transmission of beliefs and predispositions, and preferences that come from early life experiences. Especially very traumatic ones or very-

Steve Pomeranz: Right, the very, very traumatic ones which could last you an entire lifetime. Well studies have shown, getting back to the markes and this propensity to take risk or to be afraid of risk.

That the pain of loss is two times that of the pleasure of gain. And if that’s the case then down markets tend to elicit much greater fear and emotional reaction than up markets. Do you want to talk about that a bit?

Dr. Richard Peterson: Yes, that finding is quite complex because while that’s sort of an average that you’re describing there.

And the reality is that on a day-to-day basis, our sense of whether we’re losing or winning changes much more dramatically than that long term average that we experience. Also that propensity, that 2 to 1 ratio, you’ll find that there are some people it’s 17 to 1. That they’re so concerned about losses that even the US Treasury bonds feel too risky for them, for example.

And cash is too risky and it’s very stressful for them. On the other hand there are people like pathological gamblers who if they’re not taking some risk, even if it’s a disadvantageous risk, they don’t feel settled. So you have this whole [LAUGH] spectrum of people. But on average, you’re right, it’s about two to one.

And the effect that you see in the markets is that bear markets are much steeper and more dramatic than bull markets. Bull markets tend to this nice trend and then bear markets-

Steve Pomeranz: Yeah, I read the other day that bull markets rise like escalators and bear markets fall like elevators.

[LAUGH] So I think that’s kind of what you’re saying as well. There is a term, which is fancy term, but it’s an important term that I wanna describe to my listeners, and it’s called asymmetrical bias. Very fancy term you can use at cocktail parties, if anybody has cocktail parties anymore.

But tell us what it means cuz it’s very, very important.

Dr. Richard Peterson: I’m not really sure [LAUGH] in this context what that means, to be honest. [CROSSTALK]

Steve Pomeranz: Okay, so let me give you some context, sure. So this idea that if you read about a plane crashing that makes you have a fear of flying in general.

Whereas we all know that air flight is much safer than many other forms of transportation. So it’s an asymmetrical bias in the sense that something with a very small probability, you will have an outsized reaction to it.

Dr. Richard Peterson: That’s right. Right, so that’s a great point. And what you see is back in the same research from Kahneman and Tversky that showed us the two to one loss versus gain.

We also see that low probability, highly vivid risks, or highly vivid events, are overweighted. So what that means is something like Ebola where it’s very dramatic and very brutal death, and also a novel concept. Many people haven’t thought about Ebola over the years. When it becomes into our consciousness, you become very acutely aware of how can I avoid this risk.

So when you think about how many people die of the flu every year, something like more than 30,000. And then we’re talking about one person who’s died in the United States from Ebola, who actually came from West Africa. So what is the actual risk? Well clearly, it’s not justified by the amount of air time we give it versus all the other risks out there.

Steve Pomeranz: Well and in investing, maybe health care stocks go up, but then they go down. Or airline stocks will go down and then they’ll go up. I mean, we’re experiencing a similar thing with the decline in the price of oil right now. It has some negative connotations in some markets in the like.

But it also has a lot of positive connotations for the American consumer. And yet there’s a fear factor because as these big oil company shares drop, that creates fear in the marketplace. And yet is it something that’s been happening over the very short term? Are we really going to have low oil prices forever and ever?

Which is what the stock prices seem to be suggesting in some cases. Now you’ve done some work with a website, marketpsych.com, is that correct?

Dr. Richard Peterson: Yes, that’s right.

Steve Pomeranz: And you seem to measure these things on a stock by stock basis or a market by market basis. Tell us a little bit about that.

Dr. Richard Peterson: Well that’s quite a complex operation. What that is is we have software that monitors all of the news and social media in the world that we can get our hands on. So all business and financial news, we download it and we perform text analytics. We analyze what people are talking about.

We specifically look for tradable assets or references to something like interest rates that would affect the price of the tradable asset. But we then create indexes which we sell to Thomson Reuters. So from 1998 to the present we can tell you through social media what everyone’s been saying about Apple.

But in this case not only do we have all texts that people have been publishing online but we’ve converted it into numbers. And we have these time series indexes as the amount of fear about Apple, the amount of excitement. What people think about the company’s fundamental strengths, whether people trust the management team, factors like that.
And then what we do is we give that data to quant funds and banks and they test it to find what are the relationships. And we do as well, we do test it and look for the predictive relationships there.

Steve Pomeranz: So a lot of these factors act in, are they discernible patterns that happen over and over and over again?

So when a pattern does occur and you see a market going down because of some news that you’re able to somehow, with some algorithm, measure that there’s an overreaction of sort. Does that create a tradeable activity for some?

Dr. Richard Peterson: It does, it definitely does. The short term spear pattern is one of the most pronounced.

And that one is what we see with Ebola, so when airlines plummet on fears of Ebola.

Steve Pomeranz: Yeah.

Dr. Richard Peterson: Typically, a good time to buy those, give them about a week and give them a chance to settle down for a day or two. But then if you buy those, typically, they do rebound over the next week or so.

And they are these sort of what we call weekly patterns of fear and then this fear kinda dissipates. And then of course the media attention will turn back and fear will hence to again.

Steve Pomeranz: So the human condition then is really quite predictable, in a sense, or the human reaction to certain events seems to be very predictable.

In 1841 there’s a quote here from Charles Mackay the author of Extraordinary Popular Delusions and the Madness of Crowds. And I’m gonna quote here, this is 1841, we find that whole communities suddenly fix their minds upon one object and go mad it it’s pursuit. That millions of people become simultaneously impressed with one delusion, and run after it.

Till their attention is caught by some new folly more captivating than the first. And maybe I’m thinking a little bit of Apple here and maybe the iPhone.

Dr. Richard Peterson: Right, or now the iWatch.

Steve Pomeranz: The iWatch maybe is next, and also our madness with celebrities and what they’re doing from moment to moment.

And how something is so important for such a brief flash of time, and then all of a sudden it just disappears. This is a pattern, right?

Dr. Richard Peterson: Yeah, unfortunately we’ve got sort of a cultural ADHD, where we’re yanked from topic to topic. And when you look at the news and you look what’s actually significant or important, you generally don’t find much.

Until you get down to the science or technology section unfortunately. A lot of the other stuff seems to be gossip, virtually. Which is what as humans we’re attracted to most of the time.

Steve Pomeranz: There are also some other reactions that people have because of chronic fear. I’m gonna name a few of them here and get your opinion on them.
Catastrophization, which is believing the worst case is more likely than it actually is. Do you see that a lot?

Dr. Richard Peterson: Absolutely, I mean the interesting with catastrophizing, which is like you said, believing that the worst may happen. Is that as investors we often believe we should prepare for that.

Because often and in advance we’re not sufficiently diversified for the catastrophe that might happen. So when we hear about Ebola, initially we probably don’t do anything until we hear health care stocks are rocketing and airline stocks are plummeting. And then suddenly we wonder, wait a minute, how is the portfolio balanced here?

And we looked and we see something that’s unpleasant maybe. And we start moving money around, and then we get caught up in the cycle of needing to act based on this news. And naturally, by the time we get something, it’s too late.

Steve Pomeranz: Yeah, it’s happened.

Dr. Richard Peterson: Whereas the public gets it after the fact.

Steve Pomeranz: Right, here’s another one, black and white thinking. It’s all or none thinking, a global epidemic versus it’s no big deal. Either one or the other with no shades of gray. Tell us about that.

Dr. Richard Peterson: Well, that’s right. Part of our brain’s job is really to protect us from any risk that would prevent our genes from being passed on.

And even if the 1% risk of global catastrophe like nuclear holocaust or some other risk like a global pandemic. We focus on that to such an extent because it may have that 0.1% chance of destroying our lineage. And the reality is we evolved this way. That our ancestors, if they were on the savannah and they saw some animal moving in the grass.

The potential ancestors who went forward with their spear wondering if that’s a gazelle but found out it was a lion, they didn’t pass on their genes. It was the ones who ran up into a tree and waited to find out what was in the grass that passed on their genes.

Steve Pomeranz: Right, which brings me to this tendency for us as a species to herd together for protection. And which is fantastic on the savannah but in the markets it could be actually devastating.

Dr. Richard Peterson: Well, herding is a funny thing. Herding really has to do with the fact that when we don’t know what’s happening, we look to others or we look to experts.

But often experts don’t really know either so then we look at the market. Say well whoever’s selling, they know what’s going on. Which then tells us that once the selling has started, we should sell too. And that’s the danger there.

Steve Pomeranz: Yeah, so there is information in the market but it’s not necessarily accurate information.

And it’s not necessarily, since it has a lot of these short term factors that affect it, it doesn’t really necessarily say what’s really going on either. So I guess the bottom line is it’s just a fog and you just have to kind of face it. Nobody knows so you’re not gonna find really any answers over the short term.

Unfortunately, Dr. Peterson, we are out of time, let me introduce you. First of all, the site I mentioned is marketpsych.com and you can get a lot of information there, plus there’s articles. And by the way, I noticed that you wrote that you actually were in the place in Africa some years ago.

Where you had an eating experience where you thought you had truly contracted Ebola. So anybody interested in finding out more about that, really you need to go to marketpsych.com and find his article. Dr. Richard Peterson has been my guest. Thank you so much for joining us, Richard.

Dr. Richard Peterson: Thanks, Steve.