Tuesday, November 20, 2007

The Psychology of Making Money

I posted the article below as a guest author at PersonalityZone.com, a startup that I've recently funded. Personalityzone is a pretty cool, because it allows content to be customized based upon personality type.

The goal of investing is to accumulate wealth.

However, the practice of investing is an exercise in cultivating self awareness. Knowing your own personality type and your how this effects your investing behavior can make the difference between sustained success and flaming out as you pursue your financial goals.

What does psychology have to do with making money? In short, almost everything. Most investing advice begins with something that tells you how to think about something. Changing your thinking requires an awareness of not only how you currently think, but an ability to be self aware, in the moment, to recognize unproductive thought patterns. Investing also requires mastery of the animal instincts—fight or flight—and their emotional manifestations—fear and greed. The emotions can have a strong impact on the outcome of otherwise objective, analytical judgment. Understanding how emotions color judgment can not only help you avoid cognitive errors, but also allow you to capitalize on such errors when they are made by others.

Through evolution, our brains are wired at the core (the amygdala to be exact) to respond rapidly to threats and opportunities. The amygdala triggers an emotional override of the rational brain because reflexes respond much faster than the slow process of cognition. Recognizing this mechanism and delaying a decision until the emotions settle and there is time for contemplation distinguishes the rational investor from the trader.

It is interesting that the amygdala also has a central role in memory processing. It ensures that memories associated with pain and pleasure are disproportionally burned into long term memory. This was an advantageous evolutionary adaptation when we needed to remember where the saber tooth tiger lived or where to locate food or a mate. However, this feature is a maladaptation when the brain is used to invest. It causes us to remember the painful loss on a bad investment far more than the steady, unexciting returns generated across the rest of the portfolio. In fact, psychological studies have proven that one dollar of financial loss is equivalent to three dollars of gain. Such asymmetry in psychological response to a quantitative event can create inefficiency in asset prices in times of crisis. Fortunately, we have the benefit of computers and historical datasets that represent a much better history of the facts than we can remember. However, it is incumbent on the investor to objectively look at the data and not bias it with their emotionally colored memories.

Recognizing the mistakes that our brain may create in the investment process is the first step in transcending its limitations. While the brain may not change in its physical form, we can reprogram it through the effort of conscious thought. With such mindfulness in practice, the rational investor can gain an advantage for accumulating wealth by recognizing opportunities that others do not. Being centered is the secret to buying low and selling high.

Signs the Dollar is near the bottom...for now

Gisele B√ľndchen is said to be keen to avoid the US currency because of uncertainty over its strength.
When nonsense like this gets press, it raises the likelihood that the trend is likely played out.