Emotional People Make Bad Investors

The best investors tend to be more reserved, more independent, and less attuned to what other people are doing.
  • Transcript


Question: Has the financial crisis made us more risk-averse? 

Michael Mauboussin: 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? 

Michael Mauboussin: 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