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Why our Brain makes wrong Investment Decisions

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We know what our fruits and vegetables should cost at the grocer's, but we're far less certain about how much to pay for a blue-chip stock or shares in an S&P 500 Index fund.

When we spend money as consumers, we depend on the neocortex region of the brain, where our ability to reason resides. For example, if we shop for groceries and see our favorite fruit on sale at a 40 percent discount, we think 'That's a good deal. I make the best use of my money by buying it now.' And, if we hang around to watch how other shoppers behave, we see that particular item sell out sooner than usual. In other words: The demand for consumer goods rises as the price falls.

But when we spend money as investors, our brain relies on the more primitive region - the basal ganglia - which drives unconscious behavior such as herding. Let's say that 30 minutes after the stock market opens, we see that the blue-chip stock we own is down 20 percent. We know that shareholders are fleeing the stock. The basal ganglia screams, 'They know something I don't. I'd better sell too.' In this case, demand for the asset falls as the price falls. Why? Because in speculative markets, assets have no true utility. An investor buys it today in the hope that it will be worth more to another investor tomorrow. But that future value is uncertain, so the brain defaults to herding.

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