Your Irrational Brain & What Happens When You Are Loss Averse

Lots of buzz about a new study involving the brain and losing $.  We have been chatting about that on WB for a long time, and it is one of the reasons vol explodes when markets are declining.  Stats from my paper:


Asset Class Market > 10 month SMA Market < 10 month SMA Difference
US Stocks


% of time 72.92% 27.08%
Annualized Return 13.49% 3.04% -77.45%
Annualized Volatility 13.89% 19.23% 38.40%




Foreign Stocks


% of time 69.91% 30.09%
Annualized Return 14.57% 1.94% -86.71%
Annualized Volatility 14.86% 21.51% 44.76%




Bonds


% of time 76.16% 23.84%
Annualized Return 10.03% 6.29% -37.27%
Annualized Volatility 8.69% 10.15% 16.73%




Commodities


% of time 66.90% 33.10%
Annualized Return 16.21% 1.09% -93.31%
Annualized Volatility 20.78% 19.64% -5.50%




Real Estate


% of time 72.45% 27.55%
Annualized Return 14.84% -1.43% -109.64%
Annualized Volatility 13.51% 23.76% 75.90%




AVERAGE


% of time 71.67% 28.33%
Annualized Return 13.83% 2.19% -84.20%
Annualized Volatility 14.35% 18.86% 31.43%




US Stocks 1901-2008


% of time 69.88% 30.12%
Annualized Return 14.42% 3.03% -78.98%
Annualized Volatility 14.30% 24.18% 69.06%

Volatility explodes when markets are declining, and vol explodes because people get fearful and they are uncertain what to do.  Happens over and over again (the one exception is commodities which tend to be supply/demand driven based on shocks that often result in price spikes).

Some more old posts below:

Here is some other interesting research on neruroeconomics:

One of his findings was that brain images of drug addicts who are about to take another hit are indistinguishable from those of traders who are making money and about to place another trade. “That tells us pretty confidently that if you make money and make money again,” Mr. Zweig said, “it is very similar to a chemical addiction and it becomes very hard to let go.

A nice paper, “Neuroeconomics” by Cramerer and Lowenstein.  Also “Neuroscience and Economic Behavior” by Glimcher

A couple great quotes from Zweig’s excellent book “Your Money and Your Brain“:

“The neural activity of someone whose investments are making money is indistinguishable from that of someone who is high on cocaine or morphine.”

“Financial losses are processed in the same areas of the brain that respond to mortal danger.”

Jason Zweig, author of Your Money and Your Brain , has a good interview in Research magazine here.

Zweig article

Kahneman article

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