Patients with damage in the part of the brain that monitors risk make more money in a simple investing game than normal people. We can learn from this. • Everything about a modern stock market involves random events and the chance of loss. How we deal with that can determine how profitable our investing turns out. Being ‘ordinary’ sometimes doesn’t make as much profit as being a little contrary.
Figure 1. Our unconscious behaviors hurt our investment performance, but a little sideways thinking can improve our gains. Photo by Sunny Studio/Shutterstock.
• Tens of millions of households hold 401(k) and similar accounts that prohibit buying individual stocks or trading more than once or twice per month. Never fear, there’s hope! See my one-page Muscular Portfolios summary.
It’s well known that most people have a serious case of loss aversion. In one study, the majority of individuals would not take a 50/50 chance to win $200 or lose $150, even though the wins, on average, would be much larger than the losses. In general, people feel the pain of loss about twice as much as they enjoy the success of winning. (See Benartzi & Thaler, 1995.)
This aversion to loss, or more precisely to the risk of loss, holds back the gains of many individual investors. The average person underperforms whatever market he or she chooses to invest in by about 2 percentage points a year. This is called the Behavior Gap, as explained in a previous article.
Fortunately for us, researchers have found ways to quantify loss aversion and perhaps help you and me to defeat it. There are many ways that overcoming our fear of risk can make us better investors.
One key in this research is based on individuals who have a lesion in a part of their brain that manages emotions, fear, and risk. This kind of untreatable brain damage can be caused by a stroke, surgery, or disease.
Patients with this condition can actually be better drivers than normal people. When skidding on an icy road, many people hit the brakes, making their cars slide into a ditch. A patient with abnormally low levels of fear, by contrast, can be calm in icy conditions and avoid sudden moves. (See Descartes' Error: Emotion, Reason, and the Human Brain, Antonio Damasio.)
What does all this have to do with finance? It turns out that patients with this kind of brain damage outperform normal individuals in a simple investing game. The patients gained 28.5% while the ordinary players gained only 14.0%. Hey, lemme know where to get this stuff!
Understanding how the brain-damaged individuals “beat the market” can be very useful in honing our own trading skills.
Figure 2. The toss of a coin exhibits random behavior that’s like much of the ups and downs of securities indexes. Illustration by iDraw/Shutterstock.
Professors at Stanford, Carnegie Mellon, and the University of Iowa set up the following test to determine whether brain-damaged people who have a lower level of fear and risk of loss would do better than normal people at a simple coin-tossing game. A coin toss, of course, is random, just like a lot of the movements we see every day in the stock market.
- The “target” players had brain lesions that lowered their experience of fear. In most other ways, these individuals had normal IQ and intellect.
- The “normal” individuals had no history of brain damage or disease.
- A group of “control” players had brain lesions due to strokes, but not in the areas of the brain that are involved with emotion processing or fear.
- Each player was given 20 one-dollar bills and was told there would be 20 rounds of the game. In each round, the player would have to choose whether to invest or not invest $1.
- In each round, a researcher would flip a fair coin in plain sight. If the coin landed heads up, the player would lose the $1 investment. If it landed tails up, the player would receive $2.50.
- Each win gives a player so much more money than each loss costs that the odds of playing are extremely favorable.
- A logical strategy would be to invest in every round. There was only a 13% chance that the player would end up with less than $20 at the end of the game. In other words, in 87% of the cases, the player who invested in every round would end up with more money.
- On average, a repeat player’s $20 would turn into $25. That’s a 25% gain in less than an hour!
- Despite every participant understanding the rules, the brain-damaged “target” players ended the game with an average of $25.70, while the “normal” players ended with only $22.80. The individuals who felt little fear gained 28.5% vs. 14.0% for the normal individuals. (The “control” group’s performance varied insignificantly from the normal group’s.)
- What made the difference? It was all in the way the players handled losing the previous round.
- When the preceding coin toss went against them, and they had lost that investment, the brain-damaged players chose to invest in the next round 85.2% of the time. The normal players invested in the next round only 40.5% of the time.
- Since every coin toss had a likelihood of a 25% gain, staying “out of the market” was costly for the ordinary individuals. Playing the game was much more profitable for the subjects who were less held back by fear of loss.
The study behind all of the above is titled “Investment Behavior and the Negative Side of Emotion.” (For more information, see Shiv, Loewenstein, Bechara, Damasio, and Damasio, 2005.)
In the remaining parts of this column, we’ll see ways to put this kind of “behavioral finance” to good use in our own portfolios.
• Parts 2, 3, and 4 appear on May 9, 14, and 16, 2019.
With great knowledge comes great responsibility.
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