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The cost of emotion: why you make poor investment decisions

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*Note: This is Part 1 of a two-part series. Stay tuned next time on the Cordant blog, where we’ll explore strategies for overcoming your emotions to make more advantageous investment decisions. To receive Part 2 and other helpful posts directly to your inbox, sign up for our free newsletter!

 

What if I told you that someone with brain damage is a better investor than you?

Ouch, right?

Well according to a 2005 research paper entitled “Investment Behavior and the Negative Side of Emotion,” it’s true. And it’s due to the emotional response we as humans often default to when making decisions—specifically, decision-making in the face of financial losses.

The good news is there are a few strategies you can employ to counteract this emotionally driven, sub-optimal, default decision-making process when it comes to investing. We’ll cover these in a subsequent post, but first let’s discuss how emotions get in the way when it comes to investing your money.

Emotional decisions

In his 2005 study, Baba Shiv, a researcher and professor at Stanford in the area of neuroeconomics, wanted to know how emotions impacted decision-making when risk was involved.

To achieve this, he compared the decision making of “normal” investors with a set of “brain-damaged” investors. This group had damage to the regions[1] of the brain that regulate emotions.

In the study, each participant was given $20 to take part in a 20-round betting game. In each round they would have the option to invest one dollar on a coin flip. If the result of the coin flip was heads, they would lose their $1 investment. If the result was tails, they would win $2.50.

Statistically, the expected outcome for each round is $1.25—a 25% return on investment! This is clearly a favorable bet, and a fully rational decision would be to participate in 100% of the rounds.

However, what they found was that the participants with damage to the brain (which limited their emotional response) participated at a much higher rate—and were thereby more rational—than the “normal” investors.

Overall the brain damaged group invested in 84% of the rounds, compared to just 58% of rounds for the normal investors.

Loss Aversion

The reason for this wide gap is their behavior after a loss. The investors with limited emotional response (the brain damaged group) invested 85% of the time following a losing round—basically in line with their overall participation rate. However, a normal investor only participated in the subsequent round following a loss 41% of the time.

This reaction is called “loss aversion”. First demonstrated by Nobel Prize winner Daniel Kahneman and his colleague Amos Tversky, this illustrates that as humans, our preference to avoid losses is stronger than our desire to obtain gains.

This makes sense in a certain context. When man lived on the savannah with the lions, for instance, this propensity meant the difference between life and death. If you heard a rustle in the grass, it paid to go on high alert and get defensive. (90% of the time you might be wrong—but if you took no action at all, 10% of the time you were lunch.)

However, in today’s world this knee-jerk reaction is less valuable—as the financial markets require that you take some risk to earn a return. As Shiv et al. state in their paper, someone with a lower emotional response “would make more advantageous decisions than normal subjects when faced with the types of positive expected value gambles that most people routinely shun.” And that is essentially investing: a positive expected return proposition with certain risks involved.

Inhibiting Emotional Response

The moral of the story is (in Shiv’s words) “there are circumstances in which a naturally occurring emotional response must be inhibited, so that a deliberate and potentially wiser decision can be made.”

Next time on the Cordant blog, we’ll review strategies to help you remove emotion from your investments. How does one put in place a system to make these “potentially wiser decisions”?

 

Subscribe to our newsletter to learn about the steps you can put in place to help you make these wiser investment decisions. In addition to Part 2 of this post, you’ll receive helpful wealth management tips and information straight to your inbox. Just fill out the sign-up form on the right-hand side of this page.

 

[1] Patients studied had damage to either the amygdala, the orbitofrontal cortex, or the right insular/somatosensory cortex.


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Cordant, Inc. is not affiliated or associated with, or endorsed by, Intel.

Published on January 28, 2015

Isaac Presley, CFA

Isaac Presley, CFA

Isaac Presley is Director of Investments for Cordant, a wealth management firm serving current and former Intel employees. To learn more, you can read Isaac's full bio.

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