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Why+Smart+People+Make+Big+Money+Mistakes+209-224 - 2OO WHY...

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Unformatted text preview: 2OO . WHY SMART PEOPLE MAKE BIG MONEY MISTAKES tors that influence stock prices. As we’ll argue again in our book’s conclusion, you’ll likely be a lot richer if you cast your lot with a few mutual funds and forget about everything else but making regular contributions to them for the next ten, twenty, or thirty years. 8 EMOTIONAL BAGGAGE Imagine for a moment that you’re back in high school. Try to remember that time in your life as vividly as you can, specifically an instance when you felt ex- cluded by other students. It doesn’t matter whether you were on the football team or the chess team, a prom queen or a wallfl’ower. Just try to recall a sit- uation when everyone else who mattered to you so— cially was “in” and you were “out.” It may take a few moments, so we’ll wait. [Undetermined pause] Come up with something? Good. Think about iffora minute or two. Now estimate the temperature of the room in which you are sitting. A few chapters back We observed that we wouldn’t have been misguided had we written this book as one long essay about loss aversion, the bedrock principle of behavioral econom— ; 209 210 WHY SMART PEOPLE MAKE BIG MONEY MlSTAKES ics explored by the renowned research psychologists Daniel Kahneman and Amos Tversky. In many ways, we could just as honestly make the same observation regarding the sub— ject of this chapter, which we’ll loosely describe as the role of emotion in decision making in general and financial choice in particular. The book wouldn’t have read the same—our chapters and paths of reasoning would have taken different forms and shapes—but we would have reached much the same conclusions and offered similar advice. That’s because emotions are partners in all the decision- making processes that we’ve been discussing; aiders and abettors, if you will, in the rules of thumb that our brains employ to make choosing and understanding the world faster and less complicated. We’ll gladly refund the price of this book to any reader who can honestly contend that he or ' she has never regretted a decision with words to this effect: “I would have done it differently if I hadn’t been so [emo— tional state here] ! ” And like most of the judgment and decision—making bi— ases we’ve been discussing, emotions often exert their influ— ence on us in the shadows; even if we expect our moods and outlook to inform our behavior in certain ways, we may miss how they determine our actions in others. Consider, as just one example, the effect of the weather on stock markets. We refer not to what is undoubtedly a significant connection be-. tween rainfall, corn production, and the stock price of Kel— logg’s. Rather, we’re talking about the effect of weather on mood, and mood on investment decisions. Exhibit A: An ex— amination of stock markets in twenty—six countries over a fifteen-year period revealed that the amount of sunshine on a given day is, as academics like to say, positively correlated with market performance. That is, the market tends to rise more often on sunny days and fall more often on gloomy [maria/ml Baggayt 211 days, a result that researchers, finance professors David Hirshleifer and Tyler Shumway, argued was due to investors incorrectly attributing their sunshine—induced good spirits to positive economic circumstances. ’ This study doesn’t presume to prove that the prices of particular stocks over the years are affected by the moods of investors—over the long run, they reflect nothing so much as the underlying values of the businesses they represent—only that how we feel affects how we act on any given day. Recall again the words of the legendary finance prefessor Benjamin Graham, who described the stock market as a weighing ma— chine in the long run but a voting machine in the short run; sometimes how we vote is determined by how we feel when we’re at the polls. Likewise, how we spend, save, and bor— row is tied to our dispositions. Understanding how requires a Cook’s tour of the human brain. What we hope to show you over the next few pages is that your emotions “help” you make decisions in life in a manner that is sometimes quite useful but can also be highly counterproductive. Which brings us back to the exercise at the beginning of this chap— ter. We adapted it from a study by Canadian psychologists Chen—Bo Zhong and Geoffrey Leonardelli that asked thirty people to recall an experience in which they had been socially excluded, and another thirty to remember a time when they basked in the inclusive arms of others. Immediately after, the researchers asked the participants to guess the temperature of- the room in which they were sitting (ostensibly to help the maintenance staff solve a heating and air—conditioning problem). Curiously, the average guess from members of the group that thought about exclusion was three degrees colder than the average guess of group members who recalled being included. In remembering a time when they were metaphori— cally frozen out, they physically felt a little colder. Our point 212 WHY SMART PEUPLE MAKE BIG MONEY MISTAKES here is not to suggest that feeling ostracized will make you more likely to buy a sweater, although it might. Rather, we mean to emphasize again that how you feel can affect how you thin/e. This idea is both patently obvious and incalcu— lably mysterious, as is the difference between thoughts and feelings themselves. I THINKING, FEELING, AND EVERYTHING IN BETWEEN If you consider the subject for a moment, there’s probably a very good reason why our brains evolved to equate the men— tal feeling of exclusion with a physical feeling of coldness. A long time ago in human history, being shut out from a clan or tribe or village had far more serious consequences than being excluded from a high school clique. The latter leaves ’ you without a date or study partner. The former might leave you on your own in a hostile environment, without shelter, food, companionship, or protection from predators or the el— ements. Feeling a little chilly already, aren’t you? And pos— sibly a little more willing to compromise and get along with the group. Which makes sense: We are the descendants of those who understood the benefits of inclusion, not those who didn’t. ‘ ' Indeed, this is as good a time as any to discuss a field of study that, like emotions and decision making, has grown in prominence since we first wrote this book._That field is gener— ally called “neuroeconomics,” and it’s essentially the explo- ration of how the structures and functions of the brain affect our decisions, financial and otherwise. In fact, you might reasonably say that if behavioral economics is a study of the qmind’s role in financial decision making, neuroeconomics is a study of the brain’s role in the same arena. Not surpris— ingly, neuroeconomics is in many ways a bridge between the Emotional Baggage 213 study of the role of emotions in choice and the broad col- lection of heuristics that has come to define behavioral eco- nomics. And while this may sound a little complicated, it’s really not that hard to grasp. You just need to understand two basic ways the brain processes information and makes decisions, a duality that is at its core a function and manifes— tation of the physical structure of the gray matter that sits in— side all our skulls. The idea that the brain operates in two different ways, we imagine, isn’t entirely new to most readers. Exagger— ated images of “left—brain” people (emotional, creative) and “right-brain” people (analytical, logical) penetrated popular culture quite some time ago. But as the financial writer Jason Zweig writes in his excellent book Your Money (2’ Your Brain, “Right and left have less to do with it than above and below.” Essentially, the brain’s architecture can be described in broad terms as one in which the parts that we think of as more emotional or instinctual sit below the parts we think of as more analytical. The location is not as important as the distinction, for our purposes, but the instinctual parts of the brain are situated where they are mostly because they came first. Our brains, we might say (with apologies to all the neu- robiologists out there), were built from the ground floor up. That’s because if our ancestors were going to evolve higher functions, they first had to survive, and those who did were those blessed with lightning-fast reflexes and thinking pro~ cesses that maximized access to scarce resources and mini— mized vulnerability to danger situations. From these parts of the brain, composing what is sometimes called the “re— flexive system,” spring emotions like fear and disgust (which help us react to immediate dangers), or greed (which prods us to quick action when valuable resources seem ripe for the taking). They are what some might call basic or even pri- 214 WHY SMART PEUPLE MAKE BIG MONEY MISTAKES DRAW YOUR OWN CONCLUSIONS One way to understand the influence—and value—of emotions on decision making comes from research involving people with damage to areas of the brain that control the ways we “mark" emotional consequences of certain actions. in a study com- paring neurologically impaired people with undamaged par- ticipants, a team of researchers led by neurologists Antoine Bechara and Antonio Damasio had both groups play a game. The goal: Earn as much money as possible by turning over cards that specified wins and losses of varying amounts. But the decks that contained cards with the biggest payoffs also held even bigger losses. Eventually, all the players realized that the safer play was to draw from the decks that had smaller in- dividual payoffs but more modest losses as well. But the neu- rologically impaired participants never applied this lesson; they continued drawing from high-reward, high-risk decks until they went bankrupt. They did so not because they didn't understand the difference between the decks—they did—but because they couldn’t translate that understanding into smart decision mak- ing. intellectually they understood the dangers, but emotionally they were incapable of translating that knowledge into practi- cal behavior. They didn’t "feel" it. _l mal emotions, and they occupy some of the lower rungs of our unconscious thought ladder, only slightly above the au— tomatic processes that control functions like breathing. When we think of these emotions and processes, in fact, we often use metaphors of the body: “gut instinct,” “from the heart,” “hair-raising.” They are stealthy, quick,» and powerful. The other parts of the brain, housing what is often called the “reflective system,” are where more reasoned thought takes place. They are the parts that allow us to write and do long division, to negotiate and to analyze. Although quiet, they are not as stealthy; although quick by most measures, [mutinna/ Baggage 215 they are more deliberate; and, of course, they are what made us the dominant species on the planet. Needless to say, the two systems and their respective func— tions operate magnificently but also messily—sometirnes independently, sometimes redundantly, and sometimes in concert. Many of their mechanisms and processes remain to be discovered and understood. That’s where neuroeconom- ics enters the picture. Sometimes almost literally: Advances in technology (such as functional magnetic resonance imag- ing) now allow researchers to identify specific parts of the brain that are activated when we contemplate various finan— cial problems and make certain choices. We’re choosing to write about this topic now, and here, because for years much of behavioral economics research seemed to focus on the re— flective system—on conscious, reasoned judgment and deci- sion making. We say “seemed” because many of the field’s leading lights never truly ignored the brain’s duality, often anticipating much of the focus on emotions and other re- flexive processes that would come later. For example, in his acceptance speech upon receiving his Nobel Prize, Daniel Kahneman, speaking about his early days of collaboration with Amos Tversky, wrote, “In the terminology that became accepted much later, we held a two-system View, which dis— tinguished intuition from reasoning.” In any event, emotions have become an area of greater interest in recent years to many of the people who study he— havioral economics. And so throughout this chapter, which in many ways is really the beginning of the end of our book, we’re going to focus on intuition over reason, reflex over re— flection. We do this because we believe that if you are to consciously absorb some or all of what we’ve been writing about, and if you are to use it to get more satisfaction from your money and your life, you need to understand the ways 215 WHY SMART PEUPLE MAKE BIG MONEY MISTAKES your less deliberate faculties might affect the ways in which you form judgments and make decisions. And it’s highly probable that you understand less than you think you do, in much the same way investors are probably clueless about the extent to which a sunny or rainy day can affect their trading habits. We could, of course, write an entire volume about this topic; many have. Instead we’ll try to avoid the obvious and ' center our thoughts on a few key ideas that might surprise you. First we’ll look at the ways our current emotional states can affect our financial decisions—and the reasons why we have such a hard time understanding those causes and ef- fects. Then we’ll look at the way we make choices based on our forecasts about how we’ll feel in the future, and how those projections are often wildly inaccurate. SECUNDHAND EMUTIDN You need only watch one episode of Sex and the City to un— derstand how Widespread is the cultural understanding that the reflexive system can affect financial decisions. Actually, you need only look in the mirror. Who among us doesn’t own at least one shirt or piece of furniture or consumer electronic device that was purchased because we were depressed? And how many of us have bought extra life insurance because we just heard about a friend who died suddenly, leaving his wife and young children in financial straits? For that matter, who hasn’t bought some extra liability insurance when rent— ing a car, not quite sure if our own policy covers it but sud— denly terrified by. the prospect that we’ll get into a terrible accident and wind up liable for millions of dollars in dam- ages? These are examples of the reflexive system in action: gut feelings that lead us to outcomes we might not choose if our reflective system were in full control. (That said, life [maria/ml Baggage 217 is full of instances when it doesn’t matter that your rational mind knows that your emotional mind is holding too much sway; people who fear heights understand that there’s no real chance that they’ll plummet to the sidewalk from a pent- house apartment, but just try getting them onto the terrace.) Of course, you might see it as perfectly reasonable for folks to buy extra insurance in situations like these, or even to try to buy their way out of a funk with a new recliner. Even if they came from a reflexive process, the decisions taken have a perfectly logical connection to the emotions felt. And you’d be correct. What’s more relevant to this discussion is how our current emotional states can affect our decisions in less defensible and more surprising ways—that is, when the mood and decision in question are not connected. Amos Tversky and Eric Johnson explored this idea in a seminal pa- per published in 1983. Specifically, the two researchers ex— amined the ways that “incidental affective states” influence people’s assessments of risk. In other words, they sought to find out whether peOple are more likely to, say, buy extra insurance (to use the above hypotheticals) if they are more anxious or fearful than normal, regardless of the cause of that fear and anxiety. In their study, Tversky and Johnson asked participants to rate the journalistic quality of news stories depicting anxiety—provoking, depressing, uplifting, or neutral events. Then they had those same folks estimate the number of people who die each year as a result of such things as traffic accidents, leukemia, and homicide. Result: Those who’d read the anxiety—provoking or depressing arti- cles provided significantly higher estimates than those who read either neutral or uplifting stories. The implications of this study and other similar research are profound. (Recall the sunshine—and-stocks example from earlier.) Most people intuitively understand that feelings 218 WHY SMART PEOPLE MAKE BIG MONEY MISTAKES connected to an issue or decision can affect our thoughts and choices; we know we arevulnerable coffin buyers. But few people are truly cognizant that their feelings about, say, a fa— vorite sports team might affect their judgments and choices about insurance or credit cards or investing. And we’re not just picking a random topic from thin air. Consider a study by finance professors Alex Edmans, Diego Garcia, and Oyvind Norli, who found that stock market returns drop when a country’s soccer team is eliminated from a prominent tour- nament such as the World Cup, and that similar dips occur in countries following losses in other sports that are pop- ular there (like cricket, rugby, and basketball). That’s how powerful the reflexive system can be: When we feel bad—— . '— WHY SO TENSE? _| To the many causes of stock market turmoil you can add an- other: stress. Not too long ago, psychologists Anthony Porcelli and Mauricio Delgado wanted to see the level of financial risk people were willing to take depending on whether they were calm or stressed. Working with students, some of whom were forced to keep one of their hands in ice-cold water, the re- searchers orchestrated a gambling game in which participants could choose between, say, an 80 percent chance of losing 75 cents and a 20 percent chance of losing $3. Similar propo- sitions were available on the positive side: Participants could choose between, sayI an 80 percent chance of winning 75 cents and a 20 percent chance of winning $3. What Porcelli and Delgado discovered was that stressed-out students were likelier to take more risk when facing the prospect of a loss, and likelier to be more conservative when deciding between large and small gains. It’s not hard to see how this tendency might contribute to sudden market plunges: When anxiety is high, losses are large and our reflexive brains are in fifth gear. ‘ [maria/ml Baggage 219 anxious, fearful, depressed-about one thing, significant or . not, it can color our View of all things at that moment. Of course, there is more to emotion than feelingbad or good. Some emotions, notably anger, are not necessarily one or the other; you can be angry for perfectly good reasons, producing a rather satisfying state that can even prove pro— ductive. Investors who were swindled by the notorious Ber— nard Madoff, for example, have doubtless channeled some of their anger into a healthy suspicion of money managers who promise consistently impressive returns regardless of the overall performance of financial markets. More danger— ously, though, anger often is attached to feelings of certainty. This should make intuitive sense: If emotions evolved as sur- vival tools, anger would have been more helpful to our an- cestors if it went hand in hand with surety, while fear would naturally come with uncertainty. These associations have been demonstrated in a number of studies. In one, researchers found that participants who’d been asked to think about events from their lives that made them angry (providing, in theory, a condition of high cer- tainty) gave lower estimates of the likelihood that they would suffer various maladies than those who had been asked to think about events that made them afraid (low certainty). In a notable extension of this finding, a national sample of Americans was contacted two months after the 9/11 terrorist attacks on the World Trade Center ...
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