By DAVID MOON, Moon Capital
November 5, 2006
Most economic theories are built around the assumption that
individuals make rational decisions and act in their own best interests. That
sounds good in theory, but it doesn't explain how multitudes of people '
including professionals ' regularly make colossally stupid investment decisions.
Investing is nothing more than
assessing risk-reward ratios and acting accordingly, yet it seems that what
should be simple assessments often stump even educated investors.
Now there are studies to support
this anecdotal observation.
Researchers have long known that
people have asymmetric tolerance for risk. That is, the pain of a loss often
exceeds the pleasure of an equal-size gain.
If presented with a game of chance
in which the odds of a $150 gain and a $100 loss are each 50-50, rational people
should always choose to play. If the odds of winning and losing are the same,
but the rewards for winning are greater, it is logical to take the
Yet people often reject this sort of
gamble, against their own best interests.
Research now suggests the reason is
Faced with ambiguity, people often
let their emotions overcome their reason, says researcher George Lowenstein. Dr.
Lowenstein offered that 50-50 game of chance to scores of test subjects, some of
whom had damage to one of the three regions of the brain that are central to
The folks with damaged emotional
processors made significantly more rational decisions than the test group of
otherwise healthy subjects.
In other words, the emotionally
challenged subjects were better investors.
The researchers then placed test
subjects in an MRI machine and presented them with various risk-reward
scenarios. This allowed them to actually watch the brain activity and match it
to specific decision processes associated with specific questions.
The researchers found a cerebral
game of tug-of-war, in which the dorsolateral prefrontal cortex, or reasoning
area of the brain, seemed to be competing with the emotional areas of the brain.
When the reasoning area showed more activity, the respondent usually offered a
more logical answer.
While it clarifies why emotions keep
people from taking on desirable risks, this type of research doesn't explain why
some investors make irrationally high-risk decisions. Why would someone buy a
stock that is obviously overpriced or an annuity he doesn't understand?
Probably because most people are
overly influenced by the actions of others. The old saying tells us 'there's
safety in numbers.' So it's safer for ten people ' rather than one ' to walk
down a dark alley in a dangerous neighborhood in the middle of the night.
But the old saying doesn't tell us
why ten idiots would choose to put their lives in danger in the first
People do things as members of a
group they would never do individually. They aren't as bothered by making
specific investment mistakes if everyone else is making the same
Getting in touch with your emotions might make you a better
husband or mother, but it probably won't help you make good investment
David Moon is president of Moon Capital Management, a
Knoxville-based investment management firm. This article
originally appeared in the News Sentinel (Knoxville, TN).