Emotions Are Your Worst Enemy
Three books on investing reside in my office. Sitting next to Jeremy Siegel’s Stocks for the Long Run is Al Frank’s New Prudent Speculator and Benjamin Graham’s The Intelligent Investor, the bible for value investors. (Warren Buffet proclaims Ben Graham’s book to be the best investment book ever written.) Buffet continues to write “To invest successfully does not require a stratospheric IQ, unusual business insights, or inside information. What’s needed is a sound intellectual framework for making decisions and the ability to keep emotions from corroding the framework”.
All great money managers know that emotions are the investor’s worst enemy. Psychologist Kahneman and Tvesky have confirmed in studies that for most people the pain of financial loss is more than twice as intense as the pleasure of an equivalent gain.
How does this normal human tendency make for poor investment decisions? Follow me in a little arithmetic. I give you twenty $1 bills and ask you to make twenty investment decisions based on the toss of a coin. In each round, you can choose not to play and keep the dollar. If you do invest, you will receive nothing if the coin comes up heads, but you get $2.50 if it comes up tails.
Don’t play at all and you still have $20, but assuming an equal number of heads and tails, the investor who plays every single round would end up with $25. I would hope our readers would choose to play every round. However, that is not the way most people act. After a few painful losses they are likely to stop playing rather than stay in the game and let the odds work in their favor.
In “Investment Behavior and Negative Side of Emotion”, published in Psychological Science, researchers studied ‘normal’ participants and individuals with lesions in the region of the brain that controls emotions. In the coin toss game, the brain-damaged players made better investment decisions – they chose to invest more often. Having weaker emotional function, they performed more rationally than investors with normal emotions.
The full text of the report also said that this “myopic loss aversion” explains why so many prefer to invest in bonds, even though stocks have historically provided a much higher rate of return. (Equities have posted annual returns of 10.3% to 12.6%, versus 5.3% to 6.0% for bonds, over the last 80 years.)