Emotion and decision making

An emotion is defined as a collection of changes in body and brain states triggered by a dedicated brain system that responds to specific contents of one’s perceptions, actual or recalled, relative to a particular object or event (Damasio 1994, 1999). Sorensen (2008) suggests that there is a widespread tendency in consumer research to not defining emotions but, rather, to explain them by a list of emotion-words that characterizes specific discrete emotions (happy, sad etc) or by two groups of emotions, positive and negative valenced emotions.

The emotional continuum

Poels & Dewitte (2006) suggest that a distinction needs to be made between two types of emotions that operate on a continuum depending on how much cognitive processing they require before the emotion is constituted. At the left end of the continuum (see Figure 1) they placed emotions that occur automatically, referred to as “lower-order emotions” (Zajonc, 1980), which, are spontaneous and uncontrollable emotional reactions (Shiv and Fedorikhin, 1999). At the right end of the continuum Poels & Dewitte (2006) placed the emotions that depend on deeper cognitive procession of the situation, referred to as “higher-order emotions” (Lazarus, 1991), which, ‘are more complex than lower-order emotions in the sense that higher-order emotions need to be consciously labeled as a specific emotion. Some basic emotions, like fear, anger, and happiness, are situated somewhere in between lower-order and higher –order emotions’ (Poels & Dewitte, 2006).

Emotions in decision making: evidence from neuroscience

There exists extensive evidence from neuro-scientific research that emotions not only have an important effect on decision outcomes, but that emotions are closely intertwined with cognitive processes to the extent that they are seen as a key facilitator of effective decision making (Damasio, 1994; Bechara et al., 1997, Anderson et al., 1999, Bechara & Damasio, 2005). Sound and rational decision-making depends on prior accurate emotion processing (Bachara & Damasio, 2005). Bechara & Damasio (2005) studied several patients with lesions of the ventromedial prefrontal (VM) cortex who showed impairments in judgment and decision-making in real-life settings, in spite of maintaining a normal intellect. While the real-life decision-making of these patients was found to be impaired, their problem-solving abilities in laboratory settings remain largely normal. This observation of VM patients led to the somatic marker hypothesis (Damasio, 1994).

The hypothesis attributes these patients’ inability to make advantageous decisions in real-life to a defect in an emotional mechanism. Deprived of this emotional signal, these patients rely on a reasoned cost-benefit analysis of numerous and often conflicting options involving both immediate and future consequences. The term emotion tends to mean different things to the layman, the psychologist, and the physiologist, Bechara & Damasio (2005) use the term “somatic” to refer to the collection of body related responses that hallmark an emotion.

Bechara et al. (1997) and Anderson et al. (1999) studied normal subjects, VM, and amygdala patients. The goal was to assess somatic state activation while subjects were making decisions during the gambling task. The patients were asked to perform the gambling task while their Skin Conductance responses (SCRs) were recorded (Bechara et al., 1997, Anderson et al., 1999). The VM patients generated SCRs to reward or punishment, albeit the responses were slightly lower than those from normal controls, but the amygdala patients completely failed to generate SCRs in reaction to reward or punishment. Furthermore, the VM as well as the amygdale patients entirely failed to generate SCRs before picking a card. The results provide support for the notion that decision-making is guided by emotional (somatic) signaling generated in anticipation of future events. Without the ability to generate these emotional signals, the patients fail to avoid the decks that lead to painful losses, and instead they sample the wrong decks until they go broke in a manner that is very similar to how they behave in real life. Thus both emotional parts of the brain, the amygdala and VM cortex assist with rational decisions (Bechara et al. 1997; Anderson et al. 1999; Bechara & Damasio, 2005).

Emotions in financial decision making

The study of financial decision making, until recently, has been more influenced by the assumptions of financial economics than psychology. Traders within such markets have been understood as profit maximisers who act on price information, which summarises all available knowledge about asset values (Fama, 1991; Fama, 1998). These markets are designed to be transparent and have low transaction costs such that profit opportunities are only fleetingly available and market imperfections are eradicated (MacKenzie, 2006). Within this paradigm there are strong assumptions about investor rationality and the nature of investor preferences.

Understanding of markets and market behavior has been qualified by the advent of behavioral finance (De Bondt, Palm, & Wolff, 2004; Thaler, 1993), which has drawn upon the insights of cognitive psychology to incorporate the “irrational” elements of cognitive biases and collective sentiments, such as herding behavior, into models of financial decision making. However, within this field of study, the main role accorded to emotions to date is as an interference with rational cognition, or as by-products of the decision process rather than integral and primary in their effects on choice and action (e.g. Shefrin, 2000; Peterson, 2007). In contrast, the trader practitioner literature is full of references to emotion and ‘market sentiment’. ‘Market practitioners and news commentators routinely employ concepts borrowed from psychology to frame and also to make sense of market events and collective behaviour, and emotions, mood, and sentiments often take on a central role here. A burgeoning empirical literature that provides evidence on investor behaviour and market anomalies is witness to the importance of moods and emotions such as optimism, anxiety, hope, and regret in routine financial decision making’ (Fenton-O'Creevy et al., 2008).

Kamstra, Kramer, and Levi (2003) present international evidence that seasonal depression, which correlates with the length of the day, has a negative effect on stock returns. The role of emotion and its impact on trader performance has been extensively analysed and reported by Fenton-O'Creevy et al. (2008). They found that successful expert traders are more likely to engage in self-monitoring and in emotion regulation, and that this carries important benefits in terms of trading performance. Important changes have also occurred with regard to our understanding of the relationship between cognition and emotion. While there is evidence of the biasing effect of non-relevant emotions on decision-making (Loewenstein & Lerner, 2003) there is also evidence of the essential role emotions play in directing attention among multiple stimuli and in providing an experience-based affective weighting to response options (e.g. Damasio, 1994; Bechara et al., 1997). In this view, emotions are a kind of radar and rapid response system, constructing and carrying meaning across the flow of experience. Fenton-O'Creevy et al. (2008) suggest that the most important lesson to take away from these new developments is that the widespread view of emotions as an inhibiting influence on cognition is both incorrect and misleading, and that affective engagement with self and the environment is key to successful decision making.