Why emotions matter in markets
By
Bill Bonner Oct 16, 2007
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In a landmark study announced two years ago, it was revealed that investors got better returns after being knocked in the head. That came as welcome news to us. There were plenty of investors we wanted to hit on the head. Besides, we always suspected that you had to be a little mad to invest in the first place. Why? Because of the Law of Declining Marginal Utility. Broadly stated, the more you have of something, the less each additional bit of it is worth to you.
The first pound you earn is like your first real kiss; what an impression it makes! But after a few girlfriends, you can barely remember their names. And since you can’t tell the difference between your first pound and your last one, the effect of earning an extra quid is to raise your wealth overall, but to diminish the value of every single pound you ever earned. Logically, if an investment only has 50/50 odds of success, you wouldn’t bother; for every pound you earned, you’d lose a more precious one. Investors are instinctively aware of this. So, there is a gentle bias towards caution.
Cometh Princeton Professor Daniel Kahneman, who won a Nobel Prize for his work in the emerging field of neuron-economics. We are well aware that we owe to science all the modern wonders we enjoy. Without scientists’ inquiries into the nature of things, we wouldn’t have prime-time TV or sub-prime CDOs. Still, it is hard to believe that man is such a simpleton as science makes him out to be. Professor Kahneman teamed up with brain neuroscientists and began peeking into investors’ skulls. What they found was that the same areas that flare up under the influence of drugs also get a buzz going when there is money on the table. So, they got together a group of people who had been hit on the head or whose brains had been damaged in other ways; these people functioned normally otherwise, but experienced much less emotional fizz than normal people.
Then, they played a little game. Starting with $20, each one flipped a coin and called it: heads or tails. If the participant called it correctly, he won $2.50. If he called it incorrectly; he would lose only $1. If he was feeling unlucky, he could pass. Obviously, the player who wanted to maximise his returns would never pass. The odds of winning were tilted in his favour. But the players demurred anyway. Those who passed least often were those with damaged brains. So they made the most money; after 20 coin tosses, they had an average of $25.70 versus those with “normal” brains, who had $22.80.
What does science make of this? That the best investors are mentally impaired? No, the conclusion was that emotions get in the way of successful investing. Emotions caused participants to react in ‘illogical’ ways – refusing to bet, even when the odds were clearly in their favour. The un-emotional players, by contrast, did the “rational” thing more often and won more money. Now, along comes yet another study with the opposite conclusion: “Adding emotions to the decision-making process can enhance creativity, engagement and decision efficiency”, wrote Myeong-Gu Seo of the University of Maryland and Lisa Feldman Barrett of Boston College in a study released in August. “Contrary to the popular belief that the cooler head prevails, people with hot heads – those who experienced their feelings with greater intensity… achieved higher decision-making performance,” they wrote, after following 101 stockmarket investors in a simulated trading exercise over a four-week period.
What these studies show is that the people who study investors themselves are knuckleheads. If the investor does not do as they think he should, they take him for an idiot.
A “rational” investor will always seek to maximise returns, they say. Anything else is a “mistake”. But what is so irrational about wanting something other than maximum returns? Is that all that matters in life? Some investors would rather be right than rich. Others enjoy playing the game, teasing themselves with hunches, theories and techniques, even though they know most will fail. Some don’t want to appear too greedy – even to themselves.
Any moron, confronted with the coin toss game and favourable odds of 1.5/1, knows just what to do. There is no skill involved; no fun either. If he is allowed to “play” infinitely, he’ll win an infinite amount of money. On the twenty tosses, mathematically, he could expect to walk away with $35. No more, no less. Maximising efficiency, he might say, “just give me $34 now and we’ll be finished.”
Efficiency isn’t everything. What cat doesn’t spend a little idle time playing with its mouse before killing it – even though, occasionally, one will get away? What lover longs for the scientist who has perfected the efficient kiss?
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Bill Bonner
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