Investments

The Science Behind Making Money On The Stock Market

Should you invest in the stock market? Should you consult experts before doing so? Science has the answers.
The Science Behind Making Money On The Stock Market
Image credit: Shutterstock
Entrepreneur Staff
Features Writer, Entrepreneur Asia-Pacific
4 min read

 

Whether we’re actively involved or just admiring from afar, we’ve all probably dreamt of hitting it big on the stock market at some point in time. People have different views on buying stocks—some shy away completely, some indulge occasionally and some monitor its activity constantly. And now, science has gotten involved, with studies that monitor the human brain’s reaction to stock market trading and the best strategy to employ once you get involved.

What Does The Human Brain Think Of The Stock Market?

Researchers at the University of Bonn, along with colleagues from the USA and Switzerland developed a model to help understand real-life stock buying behaviour. Their efforts combine socioeconomic, psychological and neuroscientific data in an innovative way, and their findings were published in Scientific Reports in July 2018.

The study involved 157 male subjects, aged 29 to 50 years, who had to answer questions based on their economic situation, investment behaviour and willingness to take risks. The next step saw them undergoing an fMRI scan whilst repeatedly choosing between buying a safe bond or the possibility of making twice as much profit with a stock. Their experiment showed one brain structure called the anterior insular playing a vital role in the decision-making process.

Both the left and right variants of the anterior insular were particularly active when a more risk-averse test subject pressed the button to buy stocks. “The anterior insular cortex acts as a stop sign and thus cautions against risky decisions,” explained first author Alexander Niklas Häusler in an official press release. However, it was significantly less active in subjects who had already bought stocks at some point in their lives than in subjects who generally shy away from financial risks. This shows that in addition to already known economic factors such as income and education, risk optimism and risk tolerance, in particular, have a major influence on stock purchase decisions, also revealing that the brain cautions against purchasing stock when done for the first time but learns to accept it in due course.

What’s The Best Stock Market Strategy?

When you’ve made up your mind to dabble in the stock market, the first thing to do is buy a finance magazine or tune in to a finance-based show to see when the experts recommend, right? Financial experts might be your first port of call, but recent research suggests you might actually be better off going it alone.

According to research conducted at Bocconi University in Italy, investing in stocks least-favoured by market experts and pundits yielded five times as much money as the most-favoured stocks. Lead researcher Nicola Gennaioli and his team looked at stock prices and data over the past 35 years and compared it to common recommendations by stock market experts, publishing their findings online in September 2017. They found that investing in the 10 per cent of stocks most recommended by experts yielded a 3 per cent return per year on average. In contrast, putting money into the 10 per cent of stocks least recommended by experts yielded an average yearly return of 15 per cent.

Wondering why this happens? The researchers believe it’s because when a new company shows strong growth, experts get too optimistic about their stock prices. There are plenty of companies entering the markets with prodigious growth, but stocks that only increase in value over time are very rare. Stock price projections for these companies get too high, and the results are disappointing to investors who took pundits at their word.

Gennaioli explained his team’s research with a simple example in an official press release, saying,  “In a classical example, we tend to think of Irishmen as redheads because red hair is much more frequent among Irishmen than among the rest of the world. Nevertheless, only 10 per cent of Irishmen is red-headed. In our work, we develop models of belief formation that embody this logic and study the implication of this important psychological force in different domains.”

The APAC Stock Market Scenario

What does the stock market in the Asia Pacific region look like? True to the nature of the several developing economies it fosters, the region continues to deliver reasonable growth in late 2018. While China has its issues with the US, other major economies such as Japan and Australia are still performing well. Even though the ‘emerging market’ characterisation of much of Asia has seen the region tainted by association in investors’ minds, it still remains a profitable region to invest in, if just a little bit of caution is employed as well.

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