I read some interesting research findings today in market commentary from a mutual fund firm, O’Shaughnessy Asset Management.
Behavioral finance research is a growing topic on college campuses. Much of this work can help us understand decision making when risk is involved.
One fascinating study sheds light on people’s behavior in markets like this one and highlights why now is the time to buy, not sell, equities. In the study, originally reported in a Wall Street Journal article entitled “Lessons from the Brain-Damaged Investor” and led by researcher Baba Shiv of Stanford University, a group of 41 participants played an investment game where each was given $20 to start and asked to make 20 rounds of one dollar investment decisions based on a coin toss. They would choose either “invest” or “don’t invest.” If they chose “don’t invest,” they kept their dollar. If they chose “invest,” the researcher took the one dollar and flipped a coin. If it came up heads, the dollar was lost but if it came up tails, the investor was rewarded with $2.50. Clearly the most profitable strategy would be to play every round, as the expected value of each one dollar “invested” is $1.25. The twist in the study was that one group of participants had suffered brain damage which affected key emotional centers in the brain such as the orbitofrontal cortex, the amygdala, or the insula. The other participants had either no brain damage at all or brain damage that affected non-emotional centers of the brain.
Those without any emotional brain damage invested just 58 percent of the time ending with $22.80 on average. Those participants with brain damage outperformed their healthy counterparts by 14.5 percent investing 84 percent of the time and ending with an average of $25.70. The main reason participants with normal brains did so poorly was because of their behavior after a loss. Instead of recognizing the very simple positive expected value of choosing “invest”, the normal group was scared of losing twice in a row and as a result invested just 41% of the time after a loss. The damaged group maintained their overall percentage after a loss, investing 85% of the time. This study illustrates that fear, loss, and risk avoidance act as a tax on our portfolios if we do not take action to circumvent their influence.
There are many studies like this that demonstrate ability of non-emotional participants to make more rational, logical decisions. In many respects, this circumstance relates the average investor to the law of unintended consequences. In trying to reduce risk by judging patterns and expectations amid moving market conditions, many people miss opportunity and create an unintended drag on investment performance.
Please see more of our thoughts on managing risk in the previous post on June 2.
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