It is almost axiomatic in the investment world that our emotions are our enemies. Indeed, the primary focus of behavioral economics is often viewed not as how to overcome our cognitive biases, but rather how to make investment decisions without emotion and therefore better. The video above provides a quick summary of the work of Antonio Damasio (in conversation with David Brooks), who has demonstrated that when we make judgments devoid of an emotional component, those judgments are clearly inferior in much the same way decisions devoid of reason are inferior. Damasio has formulated the somatic-marker hypothesis, by which he proposes a mechanism by which emotional processes can guide or bias behavior and particularly decision-making.
According to standard economic theory, human decision-making is stripped of emotions and involves logical reasoning based on costs-benefit calculations. This theory assumes that individuals have unlimited time, knowledge and information processing power and can therefore make perfect decisions. However, practice teaches us quite the opposite. Indeed, it teaches that we are irrational and — indeed — predictably irrational (per Dan Ariely) due to various cognative biases we all suffer. Thus it is typical for investors to undermine their own success by failing to develop a long-term investment strategy, cuttng profits short while letting losses run so as, buying high/selling low, and chasing the hot new thing.
In contrast to standard economic theory and perhaps even in contrast to behavioral economics, the somatic marker hypothesis proposes that emotions play a critical role in our ability to make fast, rational decisions in complex and uncertain situations. In other words, our emotions aren’t all bad.
When we make decisions, we evaluate the incentive value of the choices available to us, using both cognitive and emotional processes. When we face complex and conflicting choices, we may be unable to decide using only cognitive processes, which may become overloaded and unable to help us decide. For example, Damasio discovered that patients with a certain type of brain damage could not use emotions to help guide their decisions based upon what had happened to them in the past. Consequently, the decisions they made were based upon individual cost-benefit analyses for every given choice situation. Doing so required very long response times and caused the ultimate decisions to be much poorer (an error at any of the intermediate steps could sabotage the outcome).
The SMH readily makes sense and is consistent with traditional economic approaches if it merely suggests that decision-making in complex and pressured situations improves with an emotional trigger. However, the research (particularly that related to the Iowa Gambling Task, explained here) suggests further that the central feature of the SMH is that emotion-related signals assist cognitive processes even when they are non-conscious.
Above the Market 