Chapter 12 Physiology of Investing Psychobiology

slide1. Chapter 12Physiology of Investing<br>
slide2. Psychobiology The branch of psychology that studies the biological foundations of behavior, emotions, and mental processes.
The American Heritage Medical Dictionary 2<br>
slide3. Gender Women are more risk averse than men
Women are also under-represented in the finance industry
For federal government workers in the Thrift Savings Plan, women invest their pension assets more conservatively
Married women invest a smaller proportion of their portfolio in stocks than married men
Women are more risk averse than men in lab settings and in investment decisions in their lives

Being more financially risk averse means that women take less risk in their investment portfolios
Note that taking less financial risk will result in lower returns and a smaller portfolio value
Thus, a gender risk gap will lead to a gender wealth gap over time 3<br>
slide4. Are gender differences due to culture, early life experiences, or some innate differences in characteristics like risk attitudes?

A lottery type experiment was conducted with students from coed schools and same-sex schools
The level of risk aversion was found to be:
girls at coed schools (highest)
girls at same-sex schools
boys at coed schools
boys at same-sex schools (lowest)
Less social interaction with boys results in girls taking more financial risk
Some of the risk aversion gender differences may be gender-stereotype learned behavior
Some may be biology 4<br>
slide5. Nature versus Nurture Our decision-making is influenced by our experiences, education, cognitive process, and social environment

But is also driven by our physiology?

What can we learn from twins, hormones, neuroeconomics, etc.? 5<br>
slide6. 6 Twins Identical Twins (monozygotic twins)
One fertilized egg splits into two
Share 100% of their genetic composition

Fraternal Twins (dizygotic twins)
Two eggs each fertilized separately
Share 50% of their genetic composition, on average<br>
slide7. Swedish Twin Registry 37,504 twins

10,842 identical
26,662 fraternal
Opposite gender: 14,252
Same gender: 12,410 Swedish Tax Agency Until 2006, required to report assets (1.5% wealth tax)
Investment data 7 Twin Investment Study Objective: Compare the investments of identical twins, fraternal twins (same and different genders), random matches
1. Participation in the stock market
2. Proportion of portfolio in the stock market
3. Level of portfolio risk<br>
slide8. Proportion Explained by Genetics 8 Amir Barnea, Henrik Cronqvist, and Stephan Siegel, “Nature or Nurture: What Determines Investor Behavior?” Journal of Financial Economics 98(2010): 583–604.<br>
slide9. Study Conclusions Regression analysis can control for the level of wealth, education, age, etc.

Portion of investment behavior explained by genetics: 9<br>
slide10. Choosing Investment Funds – a field experiment Prior to 2000, the Swedish Premium Pension Agency handled the investing decisions of mandatory individual retirement accounts.
A nationwide experiment! In 2000, people could choose how to invest their accounts from a menu of nearly 500 funds.
Choose up to five funds
Funds were color coded by risk level
68% of the eligible Swedes made an active decision, the rest passively took the default option

Merge this data with the Twin Registry
Measurements: Made Active Choice, Risk level, Chose Ethical Funds, Exhibited Return Extrapolation Bias 10<br>
slide11. Twins and Behavioral Biases – Survey Evidence Swedish twins where sent an extensive questionnaire.
Over 11,000 completed he survey, but often only one twin completed it.
1,150 identical twin pairs, 2,362 fraternal pairs (7,024 total people)

Representativeness Bias – 3 questions on likelihood people belong to groups
Sunk Cost – Going to show after lost the ticket
Illusion of Control – Discount acceptable to choose own numbers in lottery
Status Quo Bias (Default bias) – 3 questions on having switched to cheaper services
Procrastination – How often late paying bills
Time Impatient – 3 questions on the discount to receive money sooner
Loss Aversion – 3 lottery questions 11<br>
slide12. Behavioral anomalies are moderately heritable Genetic differences explain one-fifth to one-third of individual variation
Common environment accounts for only a small fraction of differences
Non-shared environment explains a large portion of variation 12 David Cesarini, Magnus Johannesson, Patrik K. E. Magnusson, and Björn Wallace, 2012. The Behavioral Genetics of Behavioral Anomalies, Management Science 58(1), 21-34.<br>
slide13. Risk and Giving – lab experiments In another study, Swedish twins were invited to come into an experimental setting, play some common economic research games, and earning some money.
141 fraternal pairs, 319 identical pairs – 920 total people

Giving: Allocate $15 between themselves and a charity for the homeless.
Risk, six decisions:
Do you want $3 for certain, or a 50/50 gamble for $15?
Do you want $4.50 for certain, or a 50/50 gamble for $15?
…
Do you want $12 for certain, or a 50/50 gamble for $15?
(one is randomly chosen and executed) 13<br>
slide14. What Drives the Twin’s Decisions? 14 David Cesarini, Christopher T. Dawes, Magnus Johannesson, Paul Lechtenstein, and Bjorn Wallace, 2009, Genetic Variation in Preferences for Giving and Risk Taking, Quarterly Journal of Economics 124(2), 809-842. Michael J. Zyphur, Jayanth Narayanan, Richard D. Arvey, Gordon Alexander, 2009. The Genetics of Economic Risk Preferences, Journal of Behavioral Decision Making 22(4), 367-377. A similar study using the Minnesota Twin registry and much fewer people, reports risk aversion decisions are 63% heritable, the balance being from unshared environment.<br>
slide15. What about other studies on families? There is strong evidence of an intergenerational transmission of investment attitudes and risk aversion. However, they do not decompose that transmission into nature and nurture.

There is some criticism that too much of the variation between identical twins and fraternal twins is attributed to genetics in twin studies.
Identical twins communicate with each other more than fraternal twins
Identical twins face similar expectations from parents, teachers, coaches, etc. 15<br>
slide16. Adoptions 16 A study attempts to decompose investment decisions into pre-birth (genetics) and post-birth (environment) effects by analyzing adoptees.
Sweden maintains information on all adoptions, including, where possible, the identity of biological and adoptive parents.
3,185 adoptees -- over 2 million non-adopted control sample
Compare adult adoptee’s investment decisions to biological parent and adoptive parent decisions. Results
Post-birth effects have twice the influence as pre-birth effects for participating in the stock market.
Pre-birth effects have little impact on the portion of equities in the portfolio.
Post-birth has four times the impact for volatility of portfolio.
Overall, Post-birth effects seem to be similar to combined twin shared and unique environment. Pre-birth effects seem similar to twin genetic influence. Sandra E. Black, Paul J. Devereux, Petter Lundborg, and Kaveh Majlesi, 2017. On the Origins of Risk-Taking in Financial Markets, Journal of Finance, forthcoming.<br>
slide17. More Adoptions 2,265 Korean babies adopted by Norwegian parents.
Financial data is available in Norway similar to Sweden.
The purpose of this study is to examine the mechanisms for intergenerational transmission of wealth and risk aversion controlling for genetic similarities.
Makes a strong case that the rearing environment has much influence on a child’s future wealth accumulation and financial risk-taking.
Use Korean-Norwegian adoptees and non-adoptee siblings to examine genetic contribution 17 Andreas Fagereng, Magne Mogstad, and Marte Rønning, 2015. Why Do Wealthy Parents Have Wealthy Children?, Norway Statistics Discussion Paper No. 813, October 21.<br>
slide18. Hormones The major classes of hormones include amines (such as adrenalin and noradrenalin), pep tides and proteins (such as oxytocin and leptin) and steroids (such as testosterone, oestradiol and cortisol).
I know of studies examining testosterone, cortisol, and oxytocin
Focus on testosterone, the male hormone
High levels of testosterone have been shown to be associated with riskier behavior in many social contexts. Therefore, it is likely that testosterone levels can impact financial decision-making.

There are 2 times testosterone may be important to your decision
Prenatal testosterone impacts brain formation and other aspects of body growth.
Current active testosterone may impact risk preferences 18<br>
slide19. Impacts of Prenatal Exposure to Testosterone Higher prenatal exposure for men leads to more masculine facial features.
Higher facial width-to-height ratio indicates higher prenatal T
Also, giving T to adolescents causes craniofacial growth
More testosterone exposure suggest higher risk taking

A study of facial masculinity of male CEOs
Firms with CEO with more masculine features show: 19 Greater financial misreporting (and thus higher SEC investigations)
Greater insider trading
Option backdating Yuping Jia, Laurence Van Lent, and Yachang Zeng, 2014. Masculinity, Testosterone, and Financial Misreporting, Journal of Accounting Research 52(5), 1195-1246.<br>
slide20. Second to Fourth Finger Ratio (2D:4D) The ratio between the length of the second and fourth fingers (2D:4D) is smaller for people that were exposed to higher prenatal testosterone 20 One study surveys 152 participants (65 female) on three risky financial decisions using lottery questions.
The subjects exposed to higher levels of prenatal testosterone are more willing to take financial risks.
This occurred for both men and women. Another study follows 45 high frequency male traders from a trading floor in London.
The 2D:4D ratio and the number of years of training, equally predicted the trader’s 20-month trading profitability Ellen Garbarino, Robert Slonim, and Justin Sydnor, 2011. Digit Ratios (2D:4D) as Predictors of Risky Decision Making for Both Sexes, Journal of Risk and Uncertainty 42, 1-26. John M. Coates, Mark Gurnell, and Aldo Rustichini, 2009. Second-to-Fourth Digit Ratio Predicts Success among High-Frequency Financial Traders, Proceedings of the National Academy of Sciences 106(2), 623-628.<br>
slide21. Twin Testosterone Transfer Hypothesis 21 For opposite sex fraternal twins, the higher level of prenatal testosterone in the amniotic fluid from the male fetus increases the pre-birth testosterone exposure of the female fetus.
Women tend to be more risk averse than men. This theory suggests the female twin of a female-male pair should take more financial risk than other women, all else equal.
Swedish Twin Registry
A study examines 9,410 females from opposite sex twin pairs and compares them to 9,093 females from same-sex twin pairs Henrik Cronqvist, Alessandro Previtero, Stephan Seigel, and Roderick E. White, 2016. The Fetal Origins Hypothesis in Finance: Prenatal Environment, the Gender Gap, and Investor Behavior, Review of Financial Studies 29(3), 739-786.<br>
slide22. Measuring Active Testosterone through Saliva In one study, they measure morning and afternoon testosterone levels in a small group (n=17) of male traders for eight consecutive business days under real working conditions.
The authors find that traders achieve a significantly greater daily profitability on days when their morning testosterone level is above their overall median level over the course of the study.
Another study examines the performance and salivary testosterone in subjects engaging in the Iowa Gambling Task.
This Task provides monetary rewards and losses over 100 rounds to test the decision-making sensitivity to rewards and losses.
In each round, the subject can draw from one of four decks of cards.
Subjects learn the reward/loses distributions from observing the outcomes of each draw.
The study shows that subjects with higher testosterone levels took greater risks (drew more from higher risk decks of cards) than lower testosterone subjects. 22 John M. Coates and J. Herbert, 2008, Endogenous Steriods and Finaicial Risk Taking on a London Trading Floor, Proceedings of the National Academy of Sciences 105(16), 6167-6172. Steven J. Stanton, Scott H. Liening, and Oliver C. Schultheiss, 2011. Testosterone is Positively Associated with Risk Taking in the Iowa Gambling Task, Hormones and Behavior 59, 252-256.<br>
slide23. Physiology Does financial decision-making effect the body?

One study wired up 10 professional traders (foreign exchange and interest rate derivatives) to measure conditions like heart rate, blood pressure, respiration, skin temperature, skin conductance response, etc., during the trading day.
These are known to measure the physical response of emotions.
Are emotions present during high risk and uncertainty events?

Periods of high volatility are associated with
high blood pressure
higher skin temperature
greater skin conductance responses
Lower experience traders exhibited higher physiological responses 23 Andrew W. Lo and Dmitry V. Repin, 2002. The Psychophysiology of Real-Time Financial Risk Processing, Journal of Cognitive Neuroscience 14(3), 323-339.<br>
slide24. More Physiology The market’s performance may cause positive or negative emotions (and the associated physical symptoms) in the general investment public.

Consider that on Black Monday (October 19, 1987), the stock market declined 25%. On that day, hospital admission in California spiked over 5%.
There was no reversal effect the next day when the market recovered half of its losses.
Overall, scholars found a strong link between stock market crashes and California hospital admissions for anxiety, panic disorder, and major depression.

The stock market can make you sick. 24 Joseph Engelberg and Christopher A. Parsons, 2016, “Worrying about the Stock Market: Evidence from Hospital Admissions,” Journal of Finance 71, 1227-1250.<br>
slide25. Genome The Human Genome Project successfully mapped human DNA
determined the sequence of nucleotide base pairs that make up human DNA and identified and mapped the location and functionality for all the genes of the human genome

Costs of genotyping continue to fall
Commercial DNA genetic testing companies (like AncestryDNA, 23andMe, Genos, and Veritas Genetics)
Funding for large scale studies 25<br>
slide26. The scale is large!
A genome consists of 23 pairs of chromosomes
Each chromosome is segmented in hundreds to thousands of functional regions called genes
Each gene can contain millions of nucleotide pairs
Result: the human genome has approximately 3 billion nucleotide pairs

Which combinations of them influence financial decision making?

Luckily, all humans share 99.6% of the genetic variation
Instead of the variation in genome, study specific variations in the brain, like differences in dopamine receptors 26<br>
slide27. The dopamine receptor D4 (DRD4) is one of the most common dopamine receptors
It may repeat the sequence of nucleotides of the DNA between 2 and 11 times (different alleles)
About three fourths of the population carries the 4-repeat sequences or the 7-repeat sequences of the allele.
There is also a wide variation in the distribution of allele repeat sequences within the population of different cultures.
Variations in DRD4 have been linked to addictive behaviors: ADHD, bipolar disorder, eating disorders, and other psychiatric conditions
Alleles with longer repeats (7 or more) are associated with reduced sensitivity to dopamine, which means such a person would need higher levels of dopamine stimulation to induce the same internal reward 27<br>
slide28. DRD4 and Financial Decision Making Three experiments with risky gambles:

Results: People with the DRD4 7R+ gene were more likely to select riskier choices, wager about 30% more on the gamble, and more willing to wager money
Conclusion: People with reduced sensitivity to dopamine will take more risk
Survey results:
The 7-repeat people:
hold fewer funds in savings
are less likely to pay off credit card balances each month
withdraw more cash than needed at the ATM
are less likely to use a debit card instead of a credit card
are less likely to purchase overdraft protection 28<br>
slide29. 29 Aging and Cognitive Ability Much of the developed world is experiencing an aging population
In the United States, around 10,000 people turn 65 every day
European demographics are similar to that of the United States
Aging in the Japanese population is even further along
Some cognitive functions decline over time as a normal aspect of aging
Cognitive ability peaks around 20 years old and then declines by 1% per year through age 80
Suggests that a person loses 60% of mental ability over a lifetime
If cognitive ability changes as one enters the senior years, it can impact investment decisions and may have major negative consequences for wealth and income<br>
slide30. The role of age-related investment needs and cognitive ability
Survey of Health, Ageing, and Retirement in Europe (SHARE)
SHARE encompassed more than 12,000 people aged 50 or older in 11 European countries

Result: an index of three cognitive abilities (math, memory, and verbal) was a strong factor in the level of financial risk participants were willing to take
People with higher levels of cognitive ability were more willing to take financial risk after controlling for age
The math-oriented cognitive measure had the most substantial influence
Verbal fluency also had a strong influence on risk taking
The memory test of cognition had only a marginal association with risk aversion
Overall, the financial risk aversion related to aging was more related to cognitive aging than changes in financial needs 30 Eric Bonsang and Thomas Dohmen. 2015. Risk attitude and cognitive aging. Journal of Economic Behavior & Organization 112:C, 112–126.<br>
slide31. Aging and Portfolio Construction and Performance Cognitive aging versus gaining investment experience—which effect dominates as investors get older?
A study uses more than 62,000 investor accounts from a U.S. discount brokerage from 1991 to 1996
Various portfolio characteristics such as performance, trading, and diversification are examined in the context of investor age and experience

Using portfolio abnormal return, age and performance exhibited an inverted U-pattern where the peak performance is around 42 years old 31 George M. Korniotis and Alok Kumar. 2011. Do older investors make better investment decisions? Review of Economics and Statistics 93:1, 244–265.<br>
slide32. Summary Women exhibit more risk aversion than men
Some of the difference is likely from social norms
Research on twins and adoptees suggest that one-fifth to one-third of financial risk aversion, financial decision making, and investment biases can be attributed to one’s genes
Variations in the receptors that regulate our sensitivity to our reward mechanisms, dopamine, do appear to be associated with novelty or risk taking 32<br>
slide33. Summary The more testosterone present in utero, or actively present in the body, the higher the tolerance for risk
As people become older, especially after age 70, they experience cognitive aging
This reduces their investment ability and increases their risk aversion
The effect causes significant declines in investment performance
The aging of the population in many countries may find their capital markets impacted by large portions of wealth being controlled by the elderly 33<br>