Understanding the Emotional Side of Investing

“There is a steady flow of wealth from the hopeful gambler to the men who know what the odds really are. Most people ignore probabilities and exaggerate risk.”
Tversky and Kohneman

Behavioral finance has become a very popular subject. Quantifying how people emotionally deal with their money (what mistakes they make over and over again and why) has produced many interesting findings. The late Amos Tversky, a Stanford professor, and Daniel Kohneman, a Princeton professor, did much of this pioneering work. One of their major discoveries is that a dollar of gain is not equal to a dollar lost in most people’s minds, certainly not when the dollar stakes were high. Who would bet his car against a neighbor’s similar car at even odds? Very few people would take this bet, because having no car is more of a bad than having two cars is a good. So, the value function is non-linear, which means most people have more displeasure in losing a large sum than the pleasure associated with winning the same amount. Most individuals want a two-thirds chance of winning to venture a big bet. Interestingly enough, most individuals don’t invest this way.
In addition, Tversky and Kohneman studied how investors used context in their decision-making process. In other words, people made up their minds differently depending on how the problem was presented to them. Perversely, when the potential gain in a transaction is stressed, people get nervous and wary; and when potential losses are played up, they are willing to assume what are in reality greater risks in order to avoid the losses.

For example, suppose a person has spent the day at the race track, and lost $140, and is considering a $10 bet on a fifteen-to-one long shot in the last race. This decision can be framed in two ways, which corresponds to two natural reference points. If the bettor focuses on the cash flow on hand, the outcomes are framed as a gain of $140 or a loss of $10. On the other hand, if the bettor frames his decision in the frame work of the whole days losses, then it’s a chance to get back to even (from a $140 loss) or to increase his loss a mere $10. Individuals do not adjust their reference points as they lose and can be expected to make bets they normally would find outrageous, even on dubious nags at fifteen to one. This is exactly how many investors have handled their investments. In reaction to huge losses in technology stocks, they have continued to not build a conservative balanced portfolio but have instead tried to chase gains. These investors are speculators still hoping that some day they may break even again.
It is always better to take your lumps and reset your reference points. Interestingly enough, the same reset is necessary with investment wins as losses. If your portfolio does exceptionally well, don’t start believing you are the new Superman of the investment world. Remember every time you flip a coin, it could come up heads or tails. The next flip of the coin isn’t influenced by results of the last toss.

If you want to minimize your investment risk, then don’t bet all your money on one filly or one spin of the roulette wheel. Instead invest in a balanced diversified portfolio; hold for the long term; and keep systematically investing each month through your 401(k) plan 403(b), IRAs and taxable account. Also, don’t forget to forgive yourself for all the wacky investment decisions you’ve made in the past. Remember to reset your reference points.

What can patience and diversification and rebalancing regularly get you? Well rewarded. The chart below is worth studying. Owning high-quality bonds in a down market can save you from serious losses. The value of being diversified is apparent when you consider the entire period returns (third column). Small cap, mid-cap and bonds all generated positive returns for the entire period while international stocks, Nasdaq composite and large cap stocks were all negative. If you had put everything you owned in the Nasdaq Composite in March 2000 at its peak and then held (not resetting your reference point) hoping to get back to breakeven, you just proved Tversky and Kohneman’s behavioral finance theories. I could update the chart above to include the last few years but it just further proves the point. Stay diversified and rebalance at least once a year.

Happy Holidays!