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Wednesday 25 March 2009

Unemotional Investing is Best

Emotionally Braindamaged People Make Better Judgement Calls on Money

Behavioral economists see humans exhibiting irrationality when it comes to dealing with money all the time. The suspicion is that this behaviour is adaptive – out in the jungle it pays to be risk adverse when approaching a snake if the last time you did so you got bit. In the stockmarket this is potentially exactly the wrong thing to do, as the stocks that did less well last year are more likely to do better this one.

Proving this isn't easy but a remarkable experiment using emotionally braindamaged people has provided further evidence that the hypothesis may well be correct.

Trying to untangle cause and effect is difficult, but if emotions are key to this maladaptive investing approach then at least one experiment suggested itself: find yourself some people who don’t experience emotions and see how they perform in a risky environment. This is exactly what Baba Shiv and colleagues (1) tried out but rather than sticking their subjects in a room with a bunch of snakes – psychology generally frowns on experiments that lead to participants dying these days – they went for a more traditional approach involving coin tossing.

Gambling on a Favourably Rigged Game

There is an unfortunate class of people who have suffered a type of brain damage which causes them to exhibit no emotions whatsoever. These people are pretty much unable to operate in the world around them as, lacking any understanding of social cues, they’re unable to interact with other people. What the experiment tested out was whether or not a group of such people would behave differently to more emotional investors in the light of investment success or failure.

The experiment was pretty simple – each subject was given $20 and a coin. On each toss of the coin they risked $1 with a $2.50 reward for guessing correctly but they had the option of not gambling and keeping the dollar. They walked away with their winnings.

So over twenty rounds if you chose not to gamble at all you would walk away with $20. However, this would be profoundly irrational because the win-loss ratio was weighted in the former’s favour. With average luck by gambling on every round you would have walked away with $25 with only a 13% chance of getting less than the starting value.

Unemotional Gambling Wins

The researchers speculated that normal investors would become more risk adverse if they lost on a previous round while, if their hypothesis was correct, the emotionless subjects would continue to gamble, being unaffected by the previous snake bite. This was exactly the finding – “normal” participants were significantly less likely to take a risk having just been burned while it made no difference to the emotionless participants. The latter group walked away with the average $25 that probability would predict while the emotionally handicapped ones got less.

So it seems that the emotional group were unable to ignore their feelings of loss after each failure and became more risk adverse while the unemotional group simply carried on playing the odds. Hence those people with a full grip on their feelings failed to capitalise on a game clearly rigged in their fashion - a description, many of us would argue, equally applicable to the stockmarket over long enough periods.

Inexperience Loses, Once More

Added to John List’s experiments suggesting that experience in markets can help people overcome trading biases, this suggests that less experienced stockmarket investors need to find ways of leaving their feelings at home before risking their capital in a jungle where snakes are all too common. As usual, the emotional and inexperienced investor is at most risk from stockmarkets.

I guess learning to embrace your inner snakes isn't easy.

(1) Investment Behavior and the Negative Side of Emotion
Baba Shiv, George Loewenstein, Antoine Bechara, Hanna Damasio, and Antonio R. Damasio
Psychological Science, Vol. 16, No. 6, 2005

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