[MUSIC] Why do we invest in financial markets instead of just putting our money into simple, almost risk-free savings accounts? Now the first answer you might want to give is, well, financial gain, increasing personal wealth. Savings accounts, while they give a steady return, that return often barely offsets inflation rates. So it's not very desirable and not a good investment in terms of increasing personal wealth. Now the second set of answers actually are also the kind of answers that somebody who enjoys gambling would give you. Right, they do it for the thrill. They do it for the uncertainty, not knowing what is going to happen. They like the emotions behind the gamble, or in this case, behind the investment. That's to say that we enjoy emotions that the market events trigger in us. But I could also come back to the first motive, the one where people say they want to increase personal wealth. And I could ask you why do you want to increase personal wealth? And the answer's likely going to be something like I would like to retire early, have a nice retirement, secure the financial future for my children, some kind of personal motive. So this seemingly objective goal of increasing personal wealth is really also driven by personal and emotional needs. The third motive relates to things like status and value. That is, how do other people perceive us when they know that we are investors, when they know what we invest in? We may enjoy outperforming our peers, our family, our friends. We may enjoy saying, I knew it, even though we didn't. The first of these three motives is really the only one from which you can derive a purely return maximization strategy. And by return here, I mean financial return. The other two motives indicate that you're willing to give up money, to pay a price to satisfy emotional or personal needs. If you're truly interested in maximizing personal financial gain, then you need to learn to identify the second and third motive in yourself and eliminate them from your decision making process. Now if you're interested in investing in the market primarily for the gambling aspect, there's nothing wrong with this per se. You just need to understand how this is going to affect you financially. You need to develop a strategy that is not going to hurt you financially in the long run. We have already seen that risk avoidance is rooted in emotions, more in particular in fear. But fear isn't the only emotion that you experience when you're trading in markets. Different market events are accompanied by different physiological and emotional responses. So any time you experience a gain or a loss, you will also experience some form of physiological or emotional response. And it is important to know that the reward that we experience when we receive financial gains from a neuro perspective, from the perspective of our brain. They're not different from the reward we experience when we get food or cocaine. It's the same region in the brain that processes these rewards. The same is true for losses. So the losses are also processed in regions of the brain that process other negative stimuli such as pain, disgust, or danger. Now besides these basic emotions like happiness and fear in response to gains and losses, you will also experience other emotions such as anxiety, anger, hope, greed. And all of those will influence the financial decisions that you're going to make. Now while your rational self may be able to work out the math and tell you what are true expected returns and risks, your emotions are not that good at this. So you will experience emotional and physiological responses to both virtual and real losses and gains. And this isn't just true for novices or non-professional traders. It is actually also true for professional traders. They too experience emotional and physiological responses as a result of market events. One interesting observation is that our trading decisions can at least in part be explained by cognitive biases and emotions. That is, if I was to look at the market, just at the actual information that's in the market, I expected returns, risks. It would be very difficult for me to predict what investors are actually going to do. However, if I take into account cognitive biases and emotions, things like overconfidence for instance, I can actually predict very well the decisions that people are going to make in the market, because it is really these cognitive biases and emotions that drive your decisions. Let me give you one specific example. What we observed in today's market is an incredibly high volume of trades. That is, people perform a lot of transactions in the market as compared to say 20 or 30 years ago. And that cannot just be explained because there are maybe more companies in the market now. Even when we account for that, people trade a lot. So why is that? Because if you just look at the, say the information in the market, that doesn't trigger trades. That should not trigger trades, right? So if you run a computational model of the market, that will tell you trade occasionally, but not as often as people do. However, if we add to this model an assumption that people are overconfident. So a lot of people just overestimate the probability of gains of certain stocks. Then that will result in a massive increase in trading volume. So it is the overconfidence that potentially triggers trades. That is to say, the simple belief that a stock is going to perform better than it actually will can trigger a lot of trades, which will not generally result in better portfolio performance. [MUSIC]
