Last month, we got a terrific response to our posting of the entire first chapter of A Demon of Our Own Design.
I want to start doing this at least once-a-month, and plan on setting up an additional space to discuss the books in more details.
Today’s book is by Dr. Richard Peterson’s Inside the Investor’s Brain: The Power of Mind Over Money.
Long time readers know that I have been a big fan of books that seek top explain how are brains are wired, and how this hard-wiring frequently sends us astray as investors.
Back in 2005, I wrote a column titled Know Thyself. Because Human nature so often runs counter to successful investing, its important to understand — and resist — many of your baser instincts.
The best book on the topic I have come previously across is Cornell Professor Thomas Gilovich’s How We Know What Isn’t So. However, that is a bit of an academic work, focusing purely on human psychology. Some people have found it to be a bit dry, and it requires some imagination to apply the lessons there to investing and markets.
Inside the Investor’s Brain suffers none of these detractions. A few things make the book work especially well: 1) The author, Dr. Richard Peterson, is a psychiatrist who specializes in neuro-science studies; 2) Peterson is also a futures trader, so he has first hand experience as to the psychology pitfalls of trading (Peterson is launching a "Quantitative Psychology based Hedge Fund in 2008); 3) By combining these two disciplines, he has been acting as a consultant to large financial firms.
I found the book accessible and easy to read, filled with amusing anecdotes and illustrative examples.
Barron’s had this very laudatory review, stating simply: "IF YOU READ BARRON’S, AND APPARENTLY you do, read this
I would modify that: If you find the intersection of human psychology, markets and investing, than you should find this book rather intriguing.
Whether or not you Humans are capable of circumventing your own wetware in order to obtain alpha (out-performance) has yet to be determined . . .
Inside the Investor’s Brain: The Power of Mind Over Money.
Here is the required and official legal notice:
"Excerpted with permission
of the publisher John Wiley & Sons, Inc. from Inside the Investor’s Brain: The Power of Mind Over Money. Copyright (c) 2007 by Richard Peterson.
This book is available at all bookstores, online booksellers and
from the Wiley web site at www.wiley.com, or call 1-800-225-5945.
You can download and print out chapter in PDF form — Download chapter 06.pdf — Below you will find all of Chapter 6 in text format, complete with endnotes.
Also, Chapter One is available online at Amazon;
CHAPTER 6: Money Emotions, Clouded Judgment
at social events, if I mention my occupation as “investment psychologist,”
people are curious. Often, their questions are market related (“Where do you
see the market in 12 months?”), and sometimes they are personal (“Why is my
spouse so hopeless with a budget?”).
2006, when Jodie heard my profession at a dinner, she asked me defensively,
“Did someone send you to talk to me?”
sure?” She said, eyeing me sideways.
yeah.” I was perplexed.
over here. I need to talk to you.” She motioned me to a quiet corner of
okay,” I said.
some pleasant conversation, Jodie opened up. She told me that she’d been having
nightmares about poor old people living under bridges. In many dreams she
herself was destitute. When she saw commercials on TV about happy older couples
in retirement, tears would come to her eyes. This had been happening for about
a year, and she didn’t really understand it, but she thought she might have a
clue is that?” I asked.
used to work at a major investment bank as a broker in the late 1990s. We were
responsible for getting retirees to buy recommended investments in their
private accounts. When I started in mid-1998, everyone wanted to buy Internet
stocks. We’d call clients, offer a few shares in an IPO [initial public
offering], and recommend some other stocks as well. They’d usually follow our
advice without questioning, and they’d be much better off for it. In late 1999,
we started offering these Internet mutual funds, and we would charge two points
on the buy, in addition to our regular commissions.”
that’s huge,” I muttered.
boss told us that we’d be fired if we couldn’t sell the fund to 80 percent of
our client accounts. It was my job to persuade dozens of mostly older retirees
to buy shares in the Internet fund. Some of them wanted to put all their money
in it, and I let them.”
in early 2001, when clients were calling me wondering why their accounts were
shrinking. I told them to hold on, that things would recover. …” She paused.
“I feel so rotten now. People really trusted me.”
took a sip of her drink and her eyes inspected the faces in the room, as if
looking for someone else to talk to.
seem like a fitting end for her story.
what?” I persisted.
“I got my
real estate license, and now I’m a real estate agent.”
mean what happened with the clients and the funds?”
know, I imagine the department was shut down. I think some of the clients lost
most of their retirement savings. Right before I left, one of the clients told
me that he was going to have to postpone retirement 10 years based on what I’d
sold him.” She studied her shoes.
talked about this before?”
really—why would I?”
like the whole episode scarred you pretty deeply.”
thought for a moment and then said matter-of-factly, “Yeah, I just feel so
terrible about the whole thing.”
wracked by guilt. Some of her clients, whom she had meant to help, had to
postpone retirement. She was harboring deep regrets about her actions, and they
were starting to surface in unlikely situations—she was crying when watching
retirees on television and seeing them in her dreams.
me she hadn’t invested in the markets at all since 2000. All of her own
retirement savings was in cash, almost as if she were paying penance for what
she had done. The worst part of the episode, for her, was that she had thought
the bubble would burst all along—she never bought the “new economy” hype, and
she regretted blithely selling Internet funds to retirees when deep inside she
knew the funds weren’t in their best interest.
and feelings of guilt can stay with people for years. The attempt to avoid them
leads people to wall off associated memories. But sometimes regrets won’t be
ignored, springing to the surface at inconvenient times or in unexpected ways.
Jodie had never accepted and worked through her experiences, so the strong
associated emotions sprang up whenever she had related experiences.
content of this book is treading on psychologically sensitive ground. Not only
is there a social taboo around money, but there is also discomfort when emotion
is openly discussed. Most people feel vulnerable during such conversations
because the thing being addressed, emotion, lies protected underneath
emotions have been considered “messy,” and they are assumed to be more damaging
than constructive for judgment. Yet research has proven that emotion is central
to both good and bad decision making. In the previous chapter you saw that
excellent intuitive decision making is often based on gut “feel.” However, at
moderate to high levels, emotions overwhelm intuition rather than support it.
This chapter describes the specific biases that arise from specific emotions.
can be short-term (lasting minutes to hours) or longer-term, such as moods
(lasting hours to weeks). When emotions are chronic, they are called attitudes,
and when they represent permanent ways of dealing with the world, they are
research literature has identified many ways in which emotions alter the
brain’s information processing and decision-making capacities.1 Emotional
decision makers often become attached to information that supports their
emotional state while ignoring contradictory evidence.2 Short-term emotions and
moods (all called emotion henceforth) arouse an inclination to take action. If
an action is not taken, then the emotion will linger.
emotions will bias judgment and decision making very subtly until they are
appropriately discharged.3 (Jodie is an excellent example of the lingering and
inadvertent expression of unprocessed emotions).
human nature to react emotionally when events do (or do not) go one’s way.
Furthermore, nothing has to happen for someone to experience emotional
reactions. The simple act of imagining possible outcomes, such as great
successes or terrible losses, stimulates emotion. Virtually every investor has
emotional reactions to market price action, especially when starting out. Most
investors have felt nervousness during sideways markets, elation during bull
markets, and intense doubt and fear during sharp market downturns. Each emotion
uniquely alters how investors think and what they subsequently do with their
some of the specific pitfalls of emotional biases in decision making? Table 6.1
summarizes the broad effects of emotion on processing and judgment.
DIFFERENCE BETWEEN POSITIVE AND NEGATIVE FEELINGS
emotions signal that life is going well, goals are being met, and resources are
adequate. In these circumstances, people are ideally situated to “broaden and
build.5 ” Negative emotions, such as fear and sadness, are characteristic of a
self-protective stance in which the primary aim is to guard existing resources
and avoid harm. Each stance, optimism and pessimism, has characteristic effects
on financial judgment.
emotions prepare the individual to seek out and undertake new goals.6 Positive
emotions, such as happiness, contentment, satisfaction, and joy, are
characterized by confidence, optimism, and self-efficacy. Happy people
interpret their own negative moods and damaging life events with more optimism
and respond to them in more positive, affirming ways than more pessimistic
people.7 There is a positive feedback effect of good mood on well-being.
Chronically positive people have better immunity and physical health than
have found numerous effects of positive mood on judgment. Subjects in a
positive emotional state tend to reduce the complexity of decisions by adopting
a simpler process of information retrieval. Happiness is associated with the
greater use of cognitive heuristics (“shortcuts”) such as stereotypes.8
Positive people disregard irrelevant information, consider fewer dimensions,
recheck less information, and take significantly less time to make a choice
than people who are feeling negative.9,10
financial gambles, positive people choose differently than negative ones. When
stakes are high, people in positive emotional states try to maintain their positive
state and avoid substantial losses.11 In contrast, if stakes are low, joyful
decision makers become risk seeking in order to benefit from the gain (though
without wagering so much as to risk their happiness). In terms of behavior,
happy people act to avoid the possibility of a large loss in order to protect
their positive emotional state.12 So while happy people make more optimistic
judgments, in situations where they foresee a reasonable likelihood of large
losses, they avoid taking risk.
emotions broaden one’s focus, negative emotions narrow it.13 Negative moods are
associated with a more ruminative and vigilant (hyperalert) thought process.14
Negative emotions predispose to excessive risk perception and overreaction to
Paul Slovic and colleagues at the Center for Decision Research measured
subjects’ personality propensities, either as “negatively reactive” or
“positively reactive.” They then asked these subjects to play a modified Iowa
Gambling Task (IGT; see Chapter 2 for description). Slovic found that
participants high in negative reactivity learned to choose fewer high-loss
options (perhaps because they are more sensitive to loss), while those high in
positive reactivity learned to choose more high-gain options.
characteristic choice behaviors led to less overall profit for positive people
playing the IGT.
provides a summary and comparison of positive and negative emotions on decision
making, judgment, and behavior.
A SELF-FULFILLING PROPHECY
an uncomfortable but intrinsic part of investing. Inevitably, some decisions
are bound to go wrong, leading to losses. Those who can’t “take a loss”
objectively will experience regret. It is very experienced investors who can be
detached from the emotional impacts of large losses. It is regret’s discomfort
that drives two of the most common behavioral biases.
behavioral finance research, one of the most prevalent biases is the tendency
to hold losing stocks longer than winning stocks. That is, most investors too
frequently “let their losers run and cut their winners short.” This is called
the disposition effect (discussed in detail in Chapters 14 and 15). Many
academics believe that the disposition effect is due to the “fear of regret.”
losing stock is tantamount to admitting that one was wrong. Feeling wrong
inspires painful regret. To avoid regret, investors hold on to losing stocks
while hoping for a comeback that will vindicate their initial buy decision.
winning stocks too soon because they fear that the stock will drop, giving back
their gains, and they will regret not having taken their paper profits off the
table while they had the chance. So whether one’s stocks are up or down,
investors often make biased decisions in order to avoid experiencing regret.
Barbara Mellers at the University of California at Berkeley designed gambling
experiments in which she found that the fear of regret leads to lower returns.
After choosing a gamble and being hit with an unexpected loss, many subjects
avoided subsequent higher-expected-value gambles that were offered. Regret
about a recent loss, even a loss as a result of a random event (such as the
flip of a coin), drove people to irrationally reduce their risk taking.15
of regret also affects how investors make initial buy and sell decisions.
Researchers conducted surveys and experiments with a large group of individual
investors and undergraduate students in the U.S. Midwest. In the survey, investors
were asked, “Thinking back to investment decisions you now regret, do you feel
more regret for: (1) selling a ‘winning’ stock too soon or (2) not selling a
‘losing’ stock soon enough?”16 Fifty-nine percent reported more regret for not
selling a loser soon enough, and 41 percent for selling a winner too soon. Each
side of the disposition equation (winners and losers) was provoked. Regret was
more aroused by not selling a losing stock soon enough.
experimenters asked subjects to participate in a game where they made their own
investment decisions (buy, sell, or hold) over several periods of a simulated
market. During the experiment, they were intermittently given the option of
following the recommendation of a hypothetical broker they met at a party.17
After they purchased a stock, they watched its price performance over a period,
and then had the option of making another decision. As the experiment
progressed, participants were asked their level of satisfaction with their
subjects reported more overall satisfaction simply from owning a stock,
regardless of the outcome. When the broker had given accurate advice, and the
subjects had followed the good advice, they reported less overall satisfaction
with the investment outcome than if they had made the buy decision
independently. Making one’s own investment decisions is more emotionally
gratifying than following a broker’s advice.
if they lost money on a stock, they felt more regret if the initial decision to
buy had been theirs alone. Following a broker’s recommendation reduced the
emotional impact of losses. Brokers’ recommendations were emotional shock
absorbers, attenuating reactions to both profits and losses.
finding may explain why most investors are willing to pay a premium for
actively managed funds and personal investment advisers. These professionals
function as intermediaries between oneself and the outcomes of one’s investment
decisions. Investors feel less emotional when deferring some responsibility for
financial outcomes onto another.
marriage performed this year in the United States, just over 40 percent will
end in divorce.18 Even when consensual, divorce has profound emotional effects
on the couple. To comfort themselves during divorce, women often seek the
solace of other friendships. Men generally have fewer intimate relationships
than women, and they may be more socially and emotionally isolated during the
transition into single life.
to my office seeking help with his investing. He explained that he had been
unsuccessfully trading volatile biotech and mining stocks. He had done such
trading in the past with modest profitability, but now he couldn’t handle the
downside swings. He felt compelled to sell out on declines and frenetically
chase fast-moving stocks higher during rallies. He had never traded so rapidly
or poorly in the past, and he wondered what was happening. Overall, he was
losing money quickly. In fact, by the time he came to see me, Doug had lost 50
percent of his retirement savings.
our first interview, Doug casually mentioned that he was going through a
divorce that had been initiated two months previously. According to Doug, the
breakup was mutual and final, and he didn’t think it was causing his investing
problems. Yet during out conversation, it became apparent that Doug was deeply
attached to his ex-wife and her family. Without her family and her circle of
friends, he had few close relationships. He had no one to talk to about his
emotional pain following the divorce. Now his deep hurt was impairing his
realizing it, Doug’s sadness and grief were increasing his risk taking.
Fortunately, recent studies have shed light on the role of sadness in risk
taking. Psychologists think sadness creates the desire to change one’s
circumstances. Sadness-driven stock transactions are fueled by hopes of quick
gains and offer a distraction from psychological pain.
common cause of low prices is pessimism—sometimes pervasive, sometimes specific
to a company or industry. We want to do business in such an environment, not
because we like pessimism but because we like the prices it produces. It’s
optimism that is the enemy of the rational buyer.”
Buffett, 1990 Chairman’s Letter to
negative emotions, while of the same valence, do not affect decision making
similarly. Researchers have performed studies to tease out the effects of
specific negative emotions. Professor Jennifer Lerner at Carnegie-Mellon
University induced states of sadness and disgust in subjects using short movie
clips. She then studied how they priced their bids and offers in a simulated
marketplace. For example, she asked participants to fill out a questionnaire in
which they chose a price they would accept in exchange for an item they had
been given (such as a pen highlighter set). In another condition, subjects
without the item indicated how much they would pay for it.
found that participants in a disgusted emotional state were emotionally driven
“to expel.” That is, disgusted people want to “get rid” of items they own, and
they do not want to accumulate new ones. As a result of the experimental
subjects’ disgust, they reduced both their bid and offer prices for the
“endowment effect” is a common cognitive bias in which people overvalue items
they already own. The endowment effect causes the average seller to demand a
higher price for an item than the average buyer thinks is reasonable. Inducing
disgust led to the elimination of the endowment effect among both buyers
(disgusted buyers lowered their average bids) and sellers (disgusted sellers
lowered the average offer price).
case of sadness, Lerner noted that “sadness triggers the goal of changing one’s
circumstances, increasing buying prices [bids] but reducing selling prices
[asks].” When the researchers provoked sadness in the subjects, the endowment
effect was reversed.19 That is, compared to people in neutral emotional states,
people who had viewed sad movie clips subsequently valued items they owned less
and items they did not possess more. Recall that disgusted people valued all
items less, whether they owned them or not.
the inversion of the endowment effect, sad people should be more likely to buy
and sell items. Lerner speculated that this inversion is responsible for
“shopping therapy” (in which people go shopping to lift their depressed
spirits), and it may drive compulsive shopping, which is a type of psychiatric
disorder. In fact, the best medication treatments for compulsive shopping are
antidepressants. Lerner notes that compulsive shoppers tend to experience
depression, that shopping tends to elevate the depressed moods of compulsive
shoppers, and that antidepressant medication tends to reduce compulsive
story of Doug, I speculated that the unacknowledged sadness around his divorce
was driving excess transactions and risk taking in the stock market. In fact,
Doug did well after he stopped trading and entered psychotherapy treatment.
When he resumed investing nine months later, he was able to maintain a
disciplined plan and he continues to trade successfully up to this writing.
FEAR AND ANGER
another series of experiments, Professor Lerner examined the roles of anger and
fear in driving financial risk taking. In advance of the experiment, she
measured participants’ dispositional levels of fear, anger, and “optimism about
the future” using standard surveys. Interestingly, she found that as levels of
both anger and happiness increase in people, they report increasing optimism
about the future. For angry people this optimism is presumably because they
feel in control. Fearful people report increasing pessimism as their level of
anxiety increases. Again, two emotions of negative valence (fear and anger)
have different effects on future expectations.21
to Lerner, emotions characterized by a sense of certainty (such as happiness
and anger) lead decision makers to rely on mental shortcuts, while emotions
characterized by uncertainty (such as anxiety and sadness) lead decision makers
to scrutinize information carefully.22,23 Anger and fear, while negative,
differ in their dimensions of control, certainty, and responsibility that
accompany them. Angry people feel more certain about the nature of an
infraction, they feel that they have more control over outcomes, and they feel
that others are responsible for the provocation. Fearful people are uncertain
where the source of danger lies, lack a sense of control over stopping it, and
are unclear who or what is responsible for the threat.24 In order to identify
the danger, they investigate their surroundings and new information more
people are averse to risk, while angry people are as comfortable with risk as
happy people. The decisive factor in risk taking is perception of control.
Fearful investors feel insecure and out of control. As a result, during market
declines, the fearful are more likely to sell out. Angry investors have
identified the enemy and feel in control of the situation. They hold on to
declining stocks because they are more certain of their position.
possible that the effects of fear and anger were seen in investor behavior
after the September 11, 2001, terrorist attacks in New York City. For the first
two weeks after the attacks, sad and fearful investors sold stock. Then, as no
further threats materialized and the identities of the Al-Qaeda perpetrators
became known, fear transformed into goal-directed anger, and the U.S. stock
market rallied strongly for several months as the initial war against the
Taliban was prepared, initiated, and successfully executed.
individuals often have trouble predicting how they will feel in the future.
They incorrectly assume that their future emotional state will resemble their
current one. As a result, they imagine that their current preferences will
remain constant into the future. Because they cannot accurately project
themselves into the future and subsequently empathize with their condition,
they have a bias of “projection” when planning for their future selves.
example, someone who receives a financial windfall may have trouble setting
aside part of it in retirement savings. He is feeling that he will always have
enough money, and when the idea of retirement savings is broached, he feels,
“Why worry about squirreling money away when I’m so flush?” Studies have found
the projection bias in people in emotional states including anxiety,25 pain,26
result of projection, most people underappreciate their powers of adaptation to
unforeseen events.28 For example, if investors anticipate that an international
crisis might drive the U.S. dollar to all-time lows, they may extrapolate
excessive damage to the American economy while underestimating the power of
U.S. businesses to adapt.29,30 They may invest less in equities, even if they
are earning lower expected returns in bonds.
error caused by projection is the exaggeration of the impact of
attention-grabbing events.31 People generally assign a level of importance to
events that is proportional to the frequency they are mentioned.
example, investors are likely to overestimate the importance of widely
publicized world events (such as Middle East conflict) to their investment
portfolio. Meanwhile, they overlook other, much more profoundly world-changing
events such as the emergence of China as an economic and political power.
Chapter 19 examines the nuances of this “attention effect” in detail.
remedy for the projection bias lies in maintaining a healthy skepticism when
attributing “moods” to the market. Another solution is to better appreciate how
one’s current and future emotional states alter one’s perceptions of financial
investors confuse emotion management with emotion control. Control often refers
to repression, which is dangerous. As noted in Table 6.1, when an emotion is
not discharged, its pressures on judgment linger until it is worked through.
Unfortunately, efforts to control emotional experience meet with little
success, and they often have the unintended effect of increasing sympathetic
nervous system activity32 (e.g., by raising blood pressure). High blood
pressure can literally be a result of “bottling up” emotion.
have found that encouraging subjects to attribute their feelings to situational
factors and neutral facts reduces the impact of current emotional state on
judgment. For example, reading a sad story lowers most peoples’ estimates of
life satisfaction. However, when people focus on the cause of their sad
feelings before rating life satisfaction, this effect is reduced.33 People who
understand why they are feeling sad (due to their reading of the sad story) are
more satisfied with life.
if one’s emotional state matches his or her personality style, then it may be
more difficult to manage. Neurotic people (with prominent anxious personality
traits) will continue to rely on clues from their anxiety to direct future
decisions, even after they have identified their anxiety as emanating from a
people first become aware of the emotional influences on their decision making,
they often have difficulty with over-or undercompensation. Increased vigilance
and self-awareness can be effective for reducing the effect of weak to moderate
emotions on decision making. It is helpful if one sets up techniques for
emotion management in advance for self-awareness interventions to be
effective.35 When in a particular emotional state, one cannot clearly see how
their thinking patterns have changed.
emotions alter one’s susceptibility to financial decision biases, an ability to
forecast future feelings could be used for personal benefit. For example, the
rare clients who tell their financial planners, “Don’t let me sell if the
market drops X percent,” are requesting that an external enforcer help them
plan in advance for periods when their financial anxiety is high.
in Chapter 5, low-level emotions underlie decision-making heuristics, such as
the affect heuristic. Heuristics make possible a rapid, unconscious
consolidation of complex information. The affect heuristic relies on subtle
emotional “tags” that indicate the relative “goodness” or “badness” of a
decision option. The affect heuristic is a process by which complex information
is simplified and given meaning. When information that has been simplified
using the affect heuristic is weighed and combined with other emotional cues,
through a filter of experience, a “gut feeling” results.
feeling” refers to the subtle, unconscious emotional judgment that forms in
response to an uncertain decision situation. If one has experience with such
situations, then gut feelings can be quite accurate judgments. Optimal “gut
feel” is the experienced interpretation of emotional cues.
relies on the rapid judgments that gut feel provides. Analytical decision making
can often be improved with intuitive input.
feel can contribute to more accurate analytical decisions, moderate or strong
emotions often lead to biased decision making. Fortunately for those who want
to improve their decision-making process, emotion can be detected and managed
with the right psychological tools, primarily through the internal honing of
emotional intelligence skills.
A lot of
technical information about moderate to strong emotions was communicated in
this chapter, and I’ll quickly summarize the effects of specific emotions here.
Regret, such as Jodie was feeling in the introductory story, prompts
conservatism with existing assets and increased risk taking with money-losing
ones (holding onto losers). Anger gives rise to mild optimism, a sense of
control, and certainty about one’s financial choices. Overall, angry investors
have less stock turnover. Sadness (perhaps unusually) leads to increased
investment risk taking and increased trading. When afraid, investors usually overestimate
danger and are more likely to believe threat-related information. When happy,
they underestimate risks and trust positive prognostications from similarly
7 through 10 detail the emotional states that most impair objective investing:
fear, stress, greed, and hubris.
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