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- Difficult start to 2016 for share market – opportunities exist for high conviction stock pickers
- Prime Value’s views on current market volatility
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- Notes from China
- Spring Cleaning The Investment Pantry
- Does Corporate Memory Have A Role In Stockpicking?
- How Do You Harvest Your Returns?
- Why Avoiding the Herd is More Important than Ever
- Safe Bets In Turbulent Times
- History: First Multinational Renaissance Business
- How Bees Invest
How Bees Invest
Andreas Rosenau, 9 November 2010
Neuroeconomics is a relatively new field looking at a mixture of economics, neuroscience and psychology and trying to understand what drives investment behavior and decisions. It not only looks investing on a theoretical and practical level, but also looks at basic biological functions.
Before making an investment it seems advisable to know something about what we invest in. But we should also know something about ourselves and how we make that decision. The brain not only adds and multiplies but intangible motives like avoiding regret or achieving a reward also influence our decision making. Neuroeconomics for example researches how losing money not only impacts our portfolio, but also our brain and body biologically. Scientists have found that the brain processes a financial loss in the same area where a mortal danger is processed.
In theory we know exactly how much risk we are comfortable with. We know that investing in small mining exploration companies can be risky. But what is risk actually? Is it the standard deviation over the last 5 or 10 years? Is it the chance to lose money? When the market goes up we might say we have a high risk tolerance. But when it goes down we become intolerant and who wants to lose money? Our risk tolerance level is not consistent. We don’t have a single level of risk tolerance but multiple levels that can change and emotions can easily impact our attitude toward risk.
Scientists made experiments with bees to understand the general risk attitude better. Bees were given the chance to feed from either blue flowers which always contained 2ml of nectar or yellow flowers which were randomly mixed so that one out of three flowers contained 6ml nectar. Theoretically the same payoff – either drink from blue flowers with 2ml or from every third yellow flower with 6ml nectar. The blue flowers paid the same reward every time while the yellow flowers were more risky and only gave the nectar over time.
The experiment showed that bees initially started out “investing” in both colors evenly. But they very quickly learned to stick to blue flowers, which always contained 2ml of nectar. They preferred it 84% of the time! For the bees not only the amount of gain is important but also the consistency of the gain. Bees thus have a strong preference for a constant supply of nectar over an irregular or variable reward.
How we experience a gain or loss depends on what it is relative to. We tend to evaluate how much the outcome varies relative to the total amount that is at risk. When the difference is high people generally gravitate away from risk to more certain outcome and most people will prefer a smaller steadier payoff over a highly variable one. To receive a triple return like from the yellow flowers, the risk was somehow too high for the bees. Too many yellow flowers were empty.
Before making an investment decision we should also understand something about how we make that decisions and what impacts our decision making. Risk tolerance is not fixed number and even small changes in our mood (a background music, constant news flow or pressure) can change how we perceive risk. Armageddon did not come when the stock market bottomed in March 2009, but our perception of risk at that time was different from what it is now with the market having recovered more than 65%. Why not take some minutes out before making an investment decision and think about the bees and the blue flowers before making an investment promising triple return. There may also be some empty flowers on the way.
(For further reading: Jason Zweig; Your Money & Your Brain, 2007 Simon & Schuster)