What happens inside your head when you're making hardball decisions about finances?
That question is at the heart of a relatively new field of science called neuroeconomics. It brings together psychology, neuroscience and economics to try to help us understand why smart people act so stupidly when it comes to their money, says Jason Zweig, author of the new book “Your Money & Your Brain: How the New Science of Neuroeconomics Can Help Make You Rich” (Simon & Schuster).
To understand why your brain might actually be holding you back from making the money you need for just about every other life goal, I asked Zweig for a little science lesson. What I learned is that our brains are divided into two parts. One produces rational thinking, and the other reacts based on emotions and intuition.“If someone throws a grenade in your lap, you're not going to think about whether it's a real grenade — you're going to jump up and scream,” explains Zweig, my colleague at “Money” magazine. “It's important to have that instantaneous emotional response, but it's also very important to know when you need to check it and make sure it's right.” You make better financial decisions when you rule your wallet with the rational part of your brain. Unfortunately, it's tough not to give in to your emotions. Those are the little voices in your head that tell you to sell when the market takes a dip. This is exactly why investors who know they should buy low and sell high often end up doing the opposite.So how do you control the ongoing tug-of-war between your ears?Respect your fearsFear plagues so many people when it comes to investing. Maybe you saw a friend lose his shirt when the dot-com bubble burst. You don't want to repeat that pattern. But if you look into the market's past, you'll see that it's always recovered after a stumble. No one said you have to jump in headfirst, though. “The best thing to do is take baby steps, the way you would if you were trying to conquer any fear,” says Zweig. “If investing is really scary for you, keep most of your money safe in the bank or a CD, and put a tiny bit at a time into the stock market.” You can gradually add more as you become comfortable, but just make sure you diversify. Putting all of your money in one place, whether it's a stock or a bond, will only increase your chances of getting wiped out.Accept that the future is unpredictableNot what Wall Street analysts want you to believe, but if you go back and read through a couple of old newspapers, you'll find that some of their predictions are wildly off. In July, when the Dow hit an all-time record high, analysts were all over the papers predicting that the market was only going to go up from there. When it proceeded to go down in August, the same analysts predicted it would keep going down. The lesson? “One of the key things is to not trust other people's judgments. In fact, don't even rely so much on your own,” says Zweig. When you read projections that, if they pan out, are going to have an effect on your money, your brain engages and you naturally start second-guessing yourself when the best thing you can do is sit tight. If that means you have to stop reading the financial pages, or walk away from conversations with friends, do it. Don't make decisions, make rules
Zweig says to put policies in place that will keep you out of trouble. The fewer choices you make, the more success you're likely to see over time. Investors often find themselves selling low out of fear, so one approach is to set a target level for what percentage of money you'll have in stocks as a whole. If the market goes up and that percentage goes over your self-imposed limit, you'll have to sell — but if you follow your rule, you'll only ever sell high. Another rule that Zweig himself follows is to automatically put the same amount of money into the market each month. “I don't do it by writing a check, because I know that I'd be afraid to write a check in months like August, when the market was low, or that I'd write too big of a check in months like July, when it was high.” By putting his contributions on autopilot, he's taking his brain out of the equation. Keep expenses low
This starts by reading the fine print of every investment you make to be sure you understand the overhead that comes with it. Then, set a cap for yourself that draws a line designating how much you'll spend on fees. Zweig suggests staying away from mutual funds that charge more than 1 percent of your money per year to manage your investment. “If your stocks return 6 or 7 percent per year into the future, then a mutual fund that charges 1.5 percent is basically taking a quarter of your return, and that's outrageous,” he explains. That's money that could be in your pocket, so it really pays to do your research before you commit to a fund or investment company.
With reporting by Arielle McGowen.
Jean Chatzky is an editor-at-large at “Money” magazine and serves as AOL’s official Money Coach. She is the personal finance editor for NBC’s “Today” show and is also a columnist for Life magazine. She is the author of four books, including “Pay It Down! From Debt to Wealth on $10 a Day” (Portfolio, 2004). To find out more, visit her Web site, .