Do you have to be brain-damaged to win at investing?
Sometimes it seems that way. A researcher wanted to study the effect emotions on investors. So he gave a group of normal and brain-damaged participants each $20 and asked them to choose whether or not to bet on a coin toss 20 successive times. If they lost, they lost a dollar; if they won, they won $2.50.
Rationally, everyone should bet every time. The risk is 50-50, the expected return from each toss is $1.25. Odds are they’ll end with $25. But it didn’t work out that way. Normal subjects invested only half the time, earning $22.80. Brain-damaged participants bet most of the time and had an average of $25.70 by the end.
The main reason normal folks did so poorly was how they reacted to losing. Instead of seeing each toss as independent, they sat out 60% of the time after a losing toss. Fear of successive losses kept them from making rational decisions.
Edvard Munch, The Scream. Source: Wikipedia
That’s the way investors behave, too. The market’s a lot like the coin-toss game, except stocks go up three quarters of the time. But after the dot-com bust and financial crisis, people swore off stocks, even though the following years were great times to be invested.
Don’t doubt in the dark what’s clear in the light. Our emotions may help us get through life, but when we’re investing, they can be our worst enemy.
Douglas R. Tengdin, CFA
Chief Investment Officer
Leave a comment if you have any questions—I read them all!