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Money and Bad Behavior By Stephen J. Butler

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John Nash, the character in the movie "A Brilliant Mind," was a Nobel prizewinner in 1994 for his experiments in game theory?the process of making mathematically rational decisions based on calculations of probability. A few weeks ago, by comparison, the Nobel Prize for economics was awarded to two academics who studied the extent to which irrational behavior ruled much economic decision-making. Meanwhile, here we sit staring at our retirement plan statements showing how much money we have lost. We feel like we ought to do something, anything, but can we be sure that our next move will be rational and profitable?

The odds are great that we will do the wrong thing. Morningstar, the mutual fund ranking service, did a study at the height of the stock market frenzy showing that the average mutual fund investor had only earned an average of 3% per year while the average fund had been gaining at 16% per year. Understanding what caused this abysmal result is what propelled professors Daniel Kahneman and Vernon Smith into the Nobel winners' circle.

We basically don't like to lose, so we become paralyzed. We would rather sit on a bad investment than take the risk of switching to a new one and losing more money as a result of our decisive action. It bothers us more to lose as a result of pro-action than as a result of inaction. So, we avoid the possibility of taking a step that runs the risk of making us feel stupid. Sitting tight offers the peaceful fog of denial and leads to something called "the status quo bias."

How we ask ourselves the question can impact what we decide to do. The stories about Kahneman's and Smith's work all cite the following simple experiment: Students were told that they could save 200 out of 600 people from a disease. Or, they could select a second option where there was a one-third chance that everyone would live and a two-thirds chance that everyone would die. Seventy-two percent of the students took option one. Then the same question was presented differently by describing option one where 400 people would die versus option two where there would be a one third chance that no one would die and two-thirds that everyone would die. Presented this way, seventy-eight percent of the students elected option two. How the question was asked determined the outcome of the poll even though the arithmetic was the same in both cases.

Of course, these were just Princeton students, but they reflect the basic truism of society in general. People will shun risks when gains, like lives saved, are at the forefront of the brain. They will take risk, on the other hand, when they are focused on avoiding a certain loss, even if the loss could be magnified further by taking the riskier course of action. Risk, remember, is a measure of future uncertainty, so option two offers more uncertainty as to the future outcome.

The relatively new field of behavioral economics represents the attempt to understand why we make so many financial decisions that are based on factors other than cold, hard, economic probability. When it comes to investment decisions, we need to decide how to ask the question. Is the glass half empty or half full? If we view our retirement account as being half full, we will want to lock in what we have today by moving out of stocks and into a money market fund. This is the equivalent of saving at least some lives (above) with 100% certainty.

If we view the glass as half empty, then we will be more inclined to accept the risks that will fill it up again. Unlike the students' experiment, our investments do not have a finite test with a beginning and an end. We have the luxury of knowing with some certainty that, given enough time, the glass will be full once again. The current bear market, when compared against historical standard deviation measurements, represents an event that has had less than a 5% chance of happening. The probability of its dropping substantially lower is perhaps one or two out of a hundred.

At this point, long-term investors with portfolios whose contributions were largely made before the big run-up of the nineties are now about even with long term stock market returns of about 10% per year. Those whose accounts are newer have a greater percentage of assets that were contributed throughout the nineties when market values were much higher. If this is the case with you, your losses are greater because you bought most of your mutual fund shares at higher prices.

In the first case, the glass is half full right now, and you can consider locking in gains by moving toward fixed income investments. In this way, you will be responding to the human tendency toward "loss aversion." Studies in behavioral economics show that the pain of a loss has far greater weight than the exhilaration from an equivalent gain. If you are inclined to want to do this, it is important to know why you feel this way. You can always overrule your feelings and you might be better off staying the course.

In the second case, you might as well view the situation as a glass half full and recognize that today's rock bottom values offer the reverse of yesterday's high values that lead to such dismal results. We will take more risk to avoid a sure loss than we would to lock in a sure gain. If we start thinking about how much we want to avoid any future losses, we will take some risks. Therefore, if we keep depositing money regularly, we are steadily reducing the average price we have paid for all of our shares combined. The result will be a glass that fills that much sooner.

This most readable book on the subject of how the mind makes financial decisions is one entitled, "Why Smart People Make Big Money Mistakes" by Gary Belsky and Thomas Gilovich. Those of us with mutual funds or credit cards owe it to ourselves to understand how money can mess with our heads. To the extent that financial advisors create value, it is because they offer a sounding board for filtering our behavioral economic urges. This contribution is difficult to measure, and our temptation is to just look at simple cause and effect results of investment advice. The paradox is that specific investment advice, like what stocks and mutual funds to buy, may have little to do with long-term financial success. In the end, advisors who double as therapists may contribute the most to our financial success.