by Marco Volpato MONACO. A conscientious examination and a good deal of realism can be useful to better manage our savings. Investing, earn and save are practices that need attention, attitude and, above all, a method.
FINANCIAL ECONOMICS: First above all, this article start with some informations about Financial Economics, the branch of economics that analyzes the use and distribution of resources in markets in which decisions are made under uncertainty. Financial decisions must often take into account future events, whether those be related to individual stocks, portfolios or or the market as a whole. Financial economics employs economic theory to evaluate how time, risk (uncertainty), opportunity costs and information can create incentives or disincentives for a particular decision. There are tons of complex trading strategies out there. And they all invariably promise to reward investors with unheard-of profits. Financial economics often involves the creation of sophisticated models to test the variables affecting a particular decision. Often, these models assume that individuals or institutions making decisions act rationally, though this is not necessarily the case.
THE RACIONAL THEORY: the Rational Theory is an economic principle that states that individuals always make prudent and logical decisions. These decisions provide people with the greatest benefit or satisfaction — given the choices available — and are also in their highest self-interest. Rational choice theory also stipulates that all complex social phenomena are driven by individual human actions. Therefore, if an economist wants to explain social change or the actions of social institutions, he needs to look at the rational decisions of the individuals that make up the whole. However, many economists do not believe in rational choice theory. Dissenters have pointed out that individuals do not always make rational utility-maximizing decisions. Irrational behavior of parties has to be taken into account in financial economics as a potential risk factor. Nobel laureate Herbert Simon proposed the theory of bounded rationality, which says that people are not always able to obtain all the information they would need to make the best possible decision. Further, economist Richard Thaler’s idea of mental accounting shows how people behave irrationally by placing greater value on some euros than others, even though all euros have the same value. They might drive to another store to save 10€ on a 20€ purchase, but they would not drive to another store to save 10€ on a 1,000€ purchase. This is an Example Against Rational Choice Theory: while rational choice theory is clean and easy to understand, it is often contradicted in the real world. For example, political factions that were in favor of the Brexit vote held on June 24, 2016, used promotional campaigns that were based on emotion rather than rational analysis. These campaigns led to the semi-shocking and unexpected result of the vote, when the United Kingdom officially decided to leave the European Union. The financial markets then responded in kind with shock, wildly increasing short-term volatility, as measured by the CBOE Volatility Index (VIX). Further, research conducted by Christopher Simms of Dalhousie University in Halifax, Canada, shows that when people are anxious, they fail to make rational decisions. Stressors that produce anxiety have been shown to actually suppress parts of the brain that aid in rational decision-making.
That being said, time has come that we must knowledge more about some recent progress in the field of NEUROECONOMICS: neuroeconomics attempts to connect economics, psychology, and neuroscience to understand economic decision-making better. The fundamentals of economic theory were built under the assumption that the intricacies of the human brain would never be discovered. Neuroeconomics has been broken down into four central areas of study; intertemporal choice, game theory, and decision making under risk and uncertainty. Each study identifies how humans balance their emotions and utility while faced with risk and uncertainty. Fundamental to the rise of neuroeconomics is a need to mend the glaring holes in conventional economic theories. Economic decision-making, in the traditional sense, suggests investors will objectively evaluate risk and react in the most rational manner. However, if history has told us anything, this has only perpetuated asset bubbles and subsequently, financial crises. That being said, neuroeconomics can provide insight into why humans do not act to optimize utility (and seemingly, irrationally). Typically, our emotions have a profound effect on our decision making. The brain often reacts more severely to losses than to gains, giving rise to irrational behavior. While emotional responses are not always suboptimal, they are rarely consistent with the concept of rationality.
However, with advances in technology, neuroscience has produced methods of analyzing brain activity.
Well, waiting forward to better understanding the mechanisms that influence our rational decision-making through neuroeconomics, herewith some practical tips, even when faced with situations that can trigger panic:
- Do not delay the decisions you can take today. The temptation to postpone the moment in which we actively devote ourselves to managing our savings is strong. An example of all is the provision of pensions: we are convinced that we have so much time to deal with the retirement age. But taking time is almost never the right solution when it comes to investment. Before you begin, the longer the time horizon on which to spread the investment, the better for your savings.
- Do not be dazzled by stellar performances. If an action has reported fairly recent returns, it is by no means said that it is able to do so in the near future. Historical averages exist (also for this): it would be good to keep an eye on them to avoid taking a wedge, pointing to a title that, after a moment’s flames, might not even have to breathe again.
- Beware of home bias. It would be important to resist temptation to concentrate exclusively on investments in your country or in securities of companies you know. Not because they are not good for themselves, but because the investing universe is wide, the opportunities are numerous and diversification is always good for the portfolio.
- Remember that markets are governed by the case. As reported above, our mind tends to create causal relationships to explain phenomena that he does not understand to appease the anxiety of the unknown. But it is sometimes counterproductive: in the case of financial markets, the present trend does not provide any guarantee or justification for the future trend.
- The losses are bad, but do not be overwhelmed. The aversion to the losses plays ugly jokes in the mind of the investor who commits gross errors in an attempt to avoid suffering. In detail, we tend to sell too soon when the investment is going well to secure the gain, and keep the position too long when it’s going wrong, in the persistent hope of recovering. Rationally you should strive to do the exact opposite.
- Do not blindly follow the mass, do not fall under the fading effect that consists in the the tendency to conform to the behavior of others, regardless of your own ideas. The waves of sales and purchases on the financial markets arise just from collective panic. Better to get out and think with your own head.
- The unexpected is the rule. Forecasting the investment world is a tough task and often even the most experienced analysts are wrong. Better forget the control mania and resign ourselves to the fact that there are risks and almost never depend on our actions. Knowing it could be soothing.
- If you decide that your investment has a long-term horizon, there is little sense to observe obsessively the market trend: you only risk being stressed unnecessarily by offering the side of excessive aversion to the losses, and then falling into the behaviors described in point 5 .
- Beware of overconfidence. Our mind tends to take on the merits of success and attribute to others the responsibility of failures.
About neuroeconomics, we end this article recalling that since 2016 the International University of Monaco (IUM) has included bilateral agreements and relationships with the Shanghai Neuroeconomics Collective Summer School (China).