Logical Investing - It's harder than you might feel

By DAVID MOON, Moon Capital Management
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 bet.

Yet people often reject this sort of gamble, against their own best interests.

Research now suggests the reason is emotional.

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 processing emotions.

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 place.

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 mistakes.

Getting in touch with your emotions might make you a better husband or mother, but it probably won't help you make good investment decisions.

David Moon is president of Moon Capital Management, a Knoxville-based investment management firm. This article originally appeared in the News Sentinel (Knoxville, TN).

Add me to your commentary distribution list.

MCM website