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Wednesday 15 December 2010

Love Your Kids, Not Your Stocks

That Love Thing

Psychologists have about as many theories about love as economists have about investing, and they have about the same success in making predictions based on their ideas. Still, both sets of social scientists plod on regardless, presumably on the basis that if there’s a market for oddball ideas they might as well try and serve it. Or maybe they’re just hoping for a date.

There are plenty of cases, though, in which it appears that investors fall in love with their investments and regardless of how fickle or downright untrustworthy their squeeze's behaviour is they’ll stick with them through thick and thin. Mostly thin. So maybe the psychology of love can tell us something about the psychology of investors?

Love Triangles

One of the problems with this love stuff is that is doesn’t mean the same thing to everyone. In fact, when you start to prise apart the various meanings it seems quite likely that it doesn’t mean the same thing to anyone. It’s certainly not an area where psychologists have ever been able to agree – although that hardly makes it unique since putting two psychologists in a room and locking the door is the modern equivalent of cockfighting, with the added bonus of still being legal.

Robert Sternberg, for instance, came up with a triangular theory of love which is based on three scales: intimacy, passion and commitment. These different elements combine in specific relationships to form different kinds of love.

My favourite is fatuous love: passion and commitment but no intimacy. Go figure.

Love Pyramids

Love plays a different part in Abraham Maslow’s hierarchy of human needs. This is usually portrayed as a pyramid, to keep the general theme of shapes going. Triangles, pyramids, whatever. Anyway, Maslow’s idea was that there are different types of needs which start from the basic physiological ones like breathing and end in self-actualization which is when one becomes everything one is capable of becoming. A skeleton, presumably, doesn't count.

Mid way up this hierarchy is the concept of love. Once the basics of breathing, eating and security are taken care of the next thing we need is to be loved and to give love. Unconditional love for a child, for instance, is necessary for it to achieve higher levels in the pyramid.

Rather more pragmatically Zick Rubin set out to measure love. Starting from the premise that love is an attitude he came up with three main components of romantic love: dependent need, predisposition to help and possessiveness. Then he developed a scale and started measuring people on it. OK, it’s not romantic but it is pragmatic.

Perhaps the best way of thinking about love is as a metaphor. Strip away the physiological underpinnings and what’s left are a set of irrational but undoubtedly real behaviours. As we’ve seen, metaphors are fertile ground for financial researchers struggling to make any sense of the investing world.

Entrepreneurial Love

So Oana Branzei and Charlene Zietsma, in Temporary Cognitions of Entrepreneurial Love looked at whether a blind love metaphor works for entrepreneurs – where they rush into ventures with passion and then only realise, as time goes by, that they’ve hooked up with a bunny boiler. As they conclude:
“Inspired by the love literature, we predicted and found that business founders would exhibit more passion and confidence in their business opportunities and would state fewer concerns than non-founders. These effects may be tempered over time, as entrepreneurs learn from feedback on prior venturing. However, these positive illusions reappear with new venturing opportunities. This study contributed by arguing that passion and its associated positive illusions are important influences on venturing decisions”
Love and Affect

Basically entrepreneurs are serial lovers, forever embracing a new partner with enthusiasm before realising that they’re just as fallible as everyone else. The blind love metaphor got picked up by Jaako Aspara and Henrikki Tikkanen who wondered whether it might be more generally applicable and related to a real psychological phenomena that we’ve met before in Risk, Stone Age Economics and the Affect Heuristic.

They identified five love metaphors - blind/optimistic, blind/confident, undemanding love, non-comparative and committed – and set out to see how these could be related to behavioural biases. The idea, of course, is that the underlying biases can arise in different forms – in human relationships in the form of irrational affection for other people and in finance in similarly peculiar love for specific investments.

They hypothesised a number of potential outcomes from such unreasoning affection for stocks. So blind/optimistic love leads to overoptimism about future returns unjustified by the fundamentals while blind/confident love leads to a further problem, underestimating the risks associated with a specific stock. These are the kinds of problems that Branzei and Zietsma detected with entrepreneurs.

Given the uncertainty surrounding future stock returns it’s also not surprising that a slight preference for one stock over another can cause a predisposition to invest in it. This type of problem has also been found in studies of collectors where the desire to possess an object can override more rational assessment of its value.

Collecting Love

Undemanding love, of the type Maslow proposes, leads to yet further issues: a willingness on the part of the investor to own a stock even if they expect lower returns. In standard financial theories this behavior is not so much irrational as supposedly impossible, yet anyone who spends any time with private investors will have met people who are so in love with their pet stocks that they can't see they're lavishing their affection on the equivalent of a pet rock. Indeed this potentially takes us a step further, towards non-comparative love where the investor doesn’t even bother to compare the potential returns of other investments against that of their favourite, because they don't care. Price is no longer important, possession is all.

Odd though this may seem it certainly seems to correspond to the behaviour of many investors, who far from spending their time analysing their portfolios and looking for alternatives seem to generally prefer to invest in a few things and hold them for a very long time, often in the face of the logic of investment returns. This, in terms of standard models of investment, is irrational indeed but if we’re being driven by psychological preferences to cosset the things we value it’s not so very irrational in human terms.

Love and Branding

Finally, Aspara and Tikkanen point the finger at committed love, where they suggest that an individual will continue to hold a stock even if they expect lower returns and higher risk from doing so. This is the financial equivalent of madness, of course, but if affect drives us to want to possess stuff then the positive feelings associated with ownership may outweigh the negative returns. It’s like being in an abusive relationship: most people would leave but some can’t because being in any relationship is better than none.

These types of biases can be exploited, of course. It’s what branding is all about. As the researchers suggest, companies may try and exploit this by presenting themselves as “socially responsible” or “environmentally friendly”.

Avoid One Night Stands

Regardless of whether an extended love metaphor really captures the essence of investing there’s very little doubt that the effect of affect towards investment can bias people into making what are quite illogical financial decisions. Certainly this doesn't seem any more absurd than believing that everyone rationally analyses every decision they make.

The subsidiary argument, though, is that investors should constantly monitor their investments to determine whether they should buy or sell. In a world of uncertainty that’s probably not the best advice, as predicting what will happen tomorrow, let alone next year, is guesswork. Relying on investments that will stand the test of time is a more sensible approach – but that doesn’t mean that the investment case shouldn’t be critically assessed on a periodic basis: blind love is no basis for an investment, but neither is a series of one-night stands.

Related articles: Risk, Stone Age Economics and the Affect Heuristic, Metaphors of Mind and Money, Unpredictably Rational

1 comment:

  1. Relying on investments that will stand the test of time is a more sensible approach

    My sense is that there is a pretty broad consensus on this point. The controversy comes when you try to implement the insight.

    Does it mean staying at the same stock allocation even after prices changes dramatically (Buy-and-Hold) or staying at the same risk level even though that requires making a dramatic change in one's stock allocation (Valuation-Informed Indexing)?