If you don’t know who you are, the stock market is an expensive place to find out.  – ADAM SMITH, The Money Game

According to Ori and Rom Brafman in their book “Sway” the National Institutes of Health (NIH) conducted a rather interesting experiment. They gathered participants and placed them in a MRI like machine and gave them a computer monitor and a joystick. Then they played a game.

Every time a circle showed on the screen, and they zapped it, they would make money. They would earn $1 for a circle with a line through it, $5 for one with two lines through it etc. If squares appeared, they also had to be zapped, or otherwise they would lose a certain amount of money. Just like the circles made money, different type squares erased different amounts of money if not zapped. Finally triangles appeared, but they had no monetary consequence. The participants were shown a running tab of their earnings as they played. 

What was interesting is that every time a circle or square appeared (money made or lost), a region of the brain called the nucleus accumbens lit up. When the triangles appeared however, the region stayed quiet. This nucleus accumbens is the region of the brain that is associated with what scientist call the “pleasure center”.

Watching the Phillies win the World Series, opening up a Porsche on a winding road, or throwing dice in Vegas are a few things that stir up the pleasure center. On the other hand, a shot of tequila, or a line of cocaine will stir up the pleasure center.

The authors go on to say that the MRI studies surprised the researchers “because it revealed that the pleasure center is also where we react to financial compensation. And the more money there is on the line, the more the pleasure center lights up. A monetary reward is– biologically speaking- like a tiny line of cocaine”.

The moral of the story is to keep ourselves in check. Trade for dollar bills and not thrills….. or you may have a very expensive habit on your hands.

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Max Brazerman is a professor at The Harvard Business School and introduces his new students to a game at the beginning of the semester. He auctions off a $20 bill with only two rules to the game.

1- The students must bid in increments of $1 and

2- The winner wins the bill but the runner-up forfeits his bid.

So the bidding begins and builds rapidly. However, without realizing, the two students with the highest bids inevitably get locked into a battle for the $20 bill. Somehow the mind-set goes from playing to win to playing not to lose.

“Students are pulled by both the momentum of the auction and the looming loss if they back down- a loss that is growing greater by the bid. The two forces, in turn, feed off each other: commitment to a chosen path inspires additional bids, driving the price up, making the potential loss loom even larger” say the authors Ori and Rom Brafman.

They go on to explain that there are three elements to the auction. The first is the optimistic stage ….the easy lure of the free lunch. This gives away to the second stage where the front runners now realize they could be in trouble. It is here where the loss aversion meets commitment. The final stage of course is digging deeper and deeper unwilling to let go.

I found it very interesting that our natural response is irrational. It seems the deeper we get in the more we dig. This loss aversion also seems to be amplified when it meets commitment and is a powerful force in our decision making. We have all been faced with the manageable loss in trading and should act rationally to control that loss while it is still small. However, when we don’t realize we are being swayed and we are focused on avoiding the loss….. our commitment to stay with it gets stronger. That is when small becomes large and even catastrophic.

We can guard against this to a certain degree by determining our loss before we play and always check our commitment at the door.

Incidentally, if you are wondering just how much these Harvard MBA’s paid for the $20 bill……….the record level was $204…..so far.

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