Question: Has the financial crisis made us more risk-averse?
: The first important thing to articulate is that when we
enjoy a gain of a dollar and the loss of a dollar which are, of course,
symmetrical, we tend to suffer two to two and a half times more from
the loss then we enjoy the gain, so there’s this asymmetry of suffering
versus joy in financial matters that’s important to lay out. The key,
though, that loss aversion ratio; there are two key points about it.
Number one is its different from person to person. So you and I may
differ in our loss aversion coefficients and that really is true across
the population and the second is: your own loss aversion coefficient may
change based on your most recent experience. So if you’ve been winning a
lot lately, you may have one risk attitude; and if you’ve been losing a
lot, a different risk attitude.
There’s one study I can’t
resist telling you about which is really fascinating in this regard. And
what they did is they took people that were unfortunately brain
damaged—this is mostly from stroke victims—and the key to that brain
damage is that it did not affect their mathematical or calculation
capabilities, so they could do math fine, they understood present
values. The part of their brain that was damaged was their emotional
seat, their ability to feel fear or greed or anguish or those kinds of
things. And then they pitted that group against a group of normal people
and here is the contest. They were given $20, and they were to play 20
rounds of a game and in each round, you could do one of two things. You
could just keep the dollar, put it in your pocket, go on to the next
round. Or you could hand your dollar over to the researcher who would
flip a coin and you would get $2.50 for the correct call and you would
lose your dollar if you had an incorrect call.
If you work out
the math of this, it’s not very complicated. You should hand your dollar
over because its $1.25 expected value versus just keeping your dollar.
And incidentally it was really cool. First five rounds pretty much
everybody gets it, so everybody's handing their dollars over, right? But
to make a long story short, at the end of the game, what they found was
the brain-damaged people ended up with 13 percent more money than the
normal people, which is a very large margin given only 20 rounds of the
game and, in particular, it's because they played many more rounds than
did the normal people and, specifically, twice as many rounds after
having suffered a loss.
All right, so you can imagine you’re
playing this game, you’re one of the normal people, you hand your dollar
over, you win some, you lose some. But if you lose a couple in a row,
you can see the thought of, you know, maybe I’ll just keep my dollar in
my pocket here, sit out a couple of rounds and then I’ll come back when
I’m feeling better. And you can see how that ports right over to the
stock market. When you’re doing well, you want to keep handing your
dollars over because you’re feeling really good about things, but if
you’ve lost for some time, you might say to yourself, you know what, I’m
perfectly happy to put this dollar in my pocket and sort of sit out a
round or two.
So how is this manifesting? Well, the S&P 500,
the widest known benchmark for the market, has been down for the last
ten years. Anybody that invested for the last ten years has lost money.
That doesn’t feel good. So what people do is they either put it in cash
and or cash balances are really high in America, or they buy bonds,
right, fixed income, a little bit more boring, less racy, but it's
equivalent to having the dollar in your pocket.
Now what allows
us to turn around? I’m not really quite sure. If the markets do do
better, people will slowly tiptoe back into the market. We had a much
better 2009 and we’re starting to see that flow now back into equity
funds and much less into bond funds.
One interesting question
is: are people scarred by this? Will a generation be scarred? And the
answer may be yes. However, if you go back into history in the 1920s and
1930s where we obviously had a very difficult market, following that
really difficult period, the markets did improve, so somebody was buying
the stocks back in that period as well. So my own sense is if the
conditions are right—valuation, economic growth and so forth—the
conditions are right for markets to do better, we will indeed see better
returns and that risk aversion will fade a little bit into the future. Question:
Do emotional people have less success as investors?
: I will say I think you’re on to a really important
thread, which is the bottom line is that people that are very outgoing
and people oriented and attuned to other people’s emotions tend to have a
difficult time investing because they feel most comfortable as being
part of the group. People that tend to be more reserved, more
independent, less attuned to people emotionally, tend to be better
investors. So it’s not a judgment call because some of these—I don’t
know if you want to call them skills—but these natural tendencies may
not serve you well in other facets of your life.
Recorded on May 14, 2010
Interviewed by Jessica Liebman