When it comes to investing - how rational are you?
[Editors note: There is a wealth of evidence that people tend to let emotions drive their investment decisions - at the worst possible times. Our job at Smart401k is to help you think and act rationally when making decisions. For investors looking for a helping hand making their long term investing decisions, this can offer great peace of mind through the best times in the market and the worst - Scott.]
by Matt Koppenheffer for Smart401k
We all want to think that we’re rational. In fact, when it comes to investing, many people like to think about themselves as not only rational, but above average. But are we?
First, I should define what exactly rational is. When it comes to economics and finance, rationality has traditionally been defined as making choices based on the greatest expected utility. Expected utility, then, is a calculation based on the probabilities of various outcomes combined with the value of each outcome.
For example, say you faced the choice of three new jobs. The only difference between the three was the pay package. In the first, you are guaranteed a $50,000 salary. In the second, you are guaranteed a $25,000 salary with a 50% chance of a $50,000 bonus and a 50% of no bonus. In the third, you are guaranteed a $40,000 salary with a 50% chance of a $10,000 bonus and a 50% chance of a $20,000 bonus. A perfectly rational person (in the world of economics) working on expected utility would choose the third job since the expected total payout of the first two jobs is $50,000, while the expected payout of the third is $55,000.
But how rational are we? Here’s a quick exercise. The following are two gambles, and in each are presented the potential payouts and the probabilities of those payouts. Read through both, and pick which gamble you’d choose for each group.
Gamble 1
(A) $500 with 100% probability
(B) $1,000 with 50% probability and $0 with 50% probability
Gamble 2
(A) -$500 with 100% probability
(B) -$1,000 with 50% probability $0 with 50% probability
What were your answers? If you chose (A) in Gamble 1 and (B) in Gamble 2, then you made the same choices that I made the first time I saw this, and the same choices that most people make when the take this gamble.
In fact, the choice combination makes no sense (from the rational economics standpoint) since the expected outcome of the pairs in both gambles is the same. In the first, the expected utility for both is $500, while in the second it’s -$500. According to economic theory, anyone who chooses the “sure thing” in the first gamble should also choose the “sure thing” in the second. Likewise, someone who chose (B) in the first gamble should also choose (B) in the second.
As part of their work in behavioral finance, Daniel Kahneman and the late Amos Tversky came up with what they called Prospect Theory — a theory which Kahneman ended up winning a Nobel Price in Economics for. Prospect Theory says that the apparent anomaly above is explained by the fact that across the board, people are generally risk averse when it comes to gains, but risk seekers when it comes to losses. In other words, we’re more likely to take a gamble when it comes to taking losses.
So how does this come back around to us and our investing decisions? Well, an effective investor is a rational one. Unfortunately, though, for many investors the preferences identified by Prospect Theory carry over to their investing. These investors are far more likely to “gamble” on a stock that is currently a loser for them, hoping that it will get back to break-even, while at the same time being too unwilling to risk gains that they’ve made on stocks that are up, and consequently selling far too soon.
So taken as a whole, this means that to be a good investor it takes more than knowing the nuts and bolts of financial metrics, valuation, and business analysis — it means identifying and mastering self-destructive psychological tendencies.
