Introduction
Typically, we view our brain as a standardized information processor when making financial decisions. However, neuroscience reveals that our brain employs complex and not always appropriate processes to interpret information, aiding us in decision-making.
The Complexity of Financial Decision-Making
Hammad Siddiqi’s study, “Information Processing in the Brain and Financial Innovations,” posits that factors like stress, biases, and the way our brain processes the unknown can simultaneously undermine or enhance our decisions, impacting our financial well-being.
Our brain isn’t merely a data processor; it’s a mechanism that builds a decision-making architecture based on predictions of the future. The study highlights that, for each financial decision, our mind compares real-life scenarios with internal models constructed from past experiences. However, when reality deviates from expected scenarios—such as lower-than-anticipated performance or a stock market downturn—our brain activates alarms to analyze the situation and consider possible corrections.
The Cognitive Cost of Discrepancy
This latent discrepancy between what we believed would happen and the actual outcome generates a cognitive cost. Our mental resources are drained adjusting expectations, and if the outcome is negative, cortisol release occurs, linked to chronic stress. This not only clouds judgment but also leads to imperfect or irrational decisions due to fear of error.
Increasing Financial Decision Complexity
In recent decades, financial decisions have become more complex and rapid due to incorporating difficult-to-use elements. Past experiences, along with the inherent complexity of these instruments themselves, make complete information lacking in most individuals’ decisions. Instruments like cryptocurrencies, automated funds, or trading apps promise efficiency but add additional complexity.
The issue isn’t innovation itself, which is both desirable and inevitable. Instead, it’s about how we process information when confronted with unknown scenarios or means of innovation.
The Risk Perception Dilution
According to the study, models that securitized credits transformed individual loans into abstract products, leading to a diluted perception of risk—as seen in the 2008 financial crisis.
If we don’t understand the functioning or underlying asset of a financial instrument, our brain may label it as a threat or underestimate it due to overconfidence. Both scenarios are negative if they don’t strictly match our reality.
The Emotional Tax on Decision-Making
The study explains why many prefer lower returns for mental peace. This isn’t irrational financial behavior but the brain prioritizing stability over potential abstract gains.
The study proposes alternatives to address this phenomenon, including workshops that help individuals understand potential risks through simulations and default options to avoid multiple decisions leading to potential risk estimation errors.
Regulatory mechanisms are also suggested, particularly for complex instruments or platforms, to clearly outline potential risks with examples, enabling more informed decisions about risk.
Key Questions and Answers
- What does the study reveal about our brain’s financial decision-making process? The study shows that our brain employs complex, not always appropriate processes to interpret information for financial decisions. Factors like stress, biases, and processing the unknown can simultaneously undermine or enhance our decisions.
- How does discrepancy between expectations and reality affect our financial decisions? This discrepancy generates a cognitive cost, draining mental resources and releasing cortisol when outcomes are negative, leading to imperfect or irrational decisions due to fear of error.
- What makes recent financial decisions more complex? Recent decades have seen an increase in complexity and rapidity of financial decisions due to incorporating difficult-to-use elements and the inherent complexity of instruments like cryptocurrencies, automated funds, or trading apps.
- How can we better understand and make financial decisions? The study proposes alternatives such as workshops using simulations to understand potential risks and regulatory mechanisms outlining complex instrument risks clearly with examples.
