Taking the Emotions Out of Investing

Market observers long have detected that investment decisions have an emotional component. Behavioral finance scholars have produced a series of studies that point out mistakes that investors tend to make in managing their portfolios. Because it is basic human psychology that is behind their actions, even experienced investors are likely to make these mistakes.

The pain of loss
Research by behavioral psychologists suggests that most individuals feel twice the pain over a financial loss as they do the pleasure of an equivalent gain. A classic 1979 study ("Prospect Theory: An Analysis of Decision Making Under Risk" by Daniel Kahneman and Amos Tversky in Econometria) found that people make different choices in equivalent situations, depending upon whether the choices are framed within the context of gain or of loss. To illustrate this phenomenon, Kahneman and Tversky gave two groups a set of choices: Group 1 was told that in addition to what they owned, they had been given $1,000. They then were asked to choose between (a) a sure gain of $500 or (b) a 50% chance to gain $1,000 and a 50% chance to gain nothing. Some 84% of the group chose (a). Group 2 was told that in addition to what they owned, they had been given $2,000. They were asked to choose between (a) a sure loss of $500 or (b) a 50% chance to lose $1,000 and a 50% chance to lose nothing. Here, 69% chose (b). But the fact is that the choices that are offered to each Group are identical in terms of the net cash amounts that the individual could receive. Yet the phrasing of the questions caused the choices to be interpreted differently.

An evolutionary twist
This loss aversion concept was tested again recently by M. Keith Chen, assistant professor at Yale School of Organization and Management, in a study under review by the Journal of Political Economy. Chen and his associates gave capuchin monkeys small disks to trade for rewards-apples, grapes or gelatin cubes. Capuchins, noted the researchers, are well-suited subjects for study because they are relatively large-brained primates, skilled problem solvers and a close evolutionary neighbor to humans. In one experiment the monkeys were asked to choose between spending a token on one visible piece of food that one-half of the time gave a return of two pieces, or two pieces of visible food that one-half of the time gave a return of only one piece. The capuchins vastly preferred the first gamble, which is essentially one-half of a chance at a bonus, than the second gamble, which is essentially one-half of a chance at a loss. "The economic view," Chen reports, "says that people are aware, rational and in control of their major decisions. Social psychology cuts in the opposite direction, maintaining that people are often unaware of the forces that dictate their behavior. We wanted to understand the interactions of these two things. What we've shown is that capuchin monkeys look remarkably like us; making rational decisions in many of the same settings that humans get right, but also make many of the same mistakes we make." "We are fighting tendencies [loss aversion] that may be biologically hard-wired," concludes Chen.

Common conflicts
Most people don't have the time or inclination to delve deeply into the field of behavioral finance. But they can look inward and examine how they have reacted to recent events. Here are the more common emotional reactions: