“I hate it! It’s like the end of world for me!” said my friend Ravi hanging his head in desperation.
“What happened?” I asked. “You lost someone in your family? Oh, I’m so sorry!”
“Oh no, not that!” he said.
“Then what? Your dog died?”
“Someone stole your Blackberry?”
“Vishal, will you let me speak?”
“Yeah, c’mon tell me what happened?” I smiled at him and asked.
“I lost a lot of money in the recent stock market crash.”
“I think all this stock market stuff is a big scam! It’s only a place for rich investors who have insider connections with companies. Small investors like me always end up as losers here.”
“Okay, so do you have anything else to say?”
“I don’t have anything else to say, Vishal. I hate this moment…I just hate this thought that I’ve lost my money!”
“C’mon Ravi, I remember you were amongst the most vocal bulls out there when stock prices were rising a few months back. And I still remember what you’d told me then.”
“What did I tell you?”
“That stocks are the best way to multiply your wealth, and that you were enjoying doing that!”
“I don’t remember saying that!”
“Let it be. Tell me how much is your portfolio down?”
“It’s down by almost 40%! Can you imagine that? 40%!”
“Hmm. And where was it a few months back?”
“Up 40%! So I came down from a gain of 40% to a loss of 40%. It’s so depressing seeing this huge loss!”
“See Ravi, what I’m getting from you is that the pain of losing 40% is far more for you than the pleasure you were deriving from gaining 40%. Is that a right assumption?”
“Of course, Vishal! Pain is always greater than pleasure. Everyone knows that!”
“Yeah, I know. But what I’m deducing from your story is that the pain of losing 40% is far-far greater than the pleasure of gaining an exactly equivalent amount.”
“I don’t know what you’re trying to conclude, but I think you are…maybe…right.”
What’s ailing Ravi?
You see, Ravi’s behavior or his treatment of his stock market gains and losses isn’t weird.
In fact, this is exactly the way most investors treat their gains and losses from stocks.
So, if a 40% gain brings us X pleasure, a 40% loss would bring us 2X pain.
In fact, there was a scientific study done in 2005 to prove this point.
A team of researchers from Stanford University, Carnegie Mellon University, and the University of Iowa analyzed the investment decisions made by people who were unable to feel emotions due to brain damage.
The subjects’ IQs (ability to do simple mathematical calculations and make simple decisions) were normal, and the parts of their brains responsible for logic and cognitive reasoning were unaffected.
Participants were given US$ 20 at the beginning of a 20-round gambling game. At the beginning of each round, the participants were asked if they wanted to risk US$1 on a coin toss.
Those that said no kept their money. Those that agreed to participate earned US$ 2.50 if they won the coin toss, but had to give up their US$ 1 if they lost.
Everyone then proceeded to the next round, in which the same steps were repeated.
Although the participants could decline to take part in any or all of the rounds, it made the most sense—financially speaking—to play each time because the potential return was so much greater than the potential loss.
“From a logical standpoint, the right thing to do was to invest in every round,” said Baba Shiv, Professor of marketing at the Stanford Graduate School of Business and co-author of the study.
“With a 50-50 chance of winning, the expected value of playing each round was US$ 1.25 (or 50% of US$ 2.50), while the expected value of not playing was just US$ 1.”
Of the 41 participants in the study, 15 had suffered damage in the areas of the brain that affected emotions, and these were the people who took the most profitable approach to the game.
They invested in 84% of the rounds, earning an average of US$ 25.70. In contrast, normal participants invested in just 58% of the rounds, earning an average of US$ 22.80.
All right, so you can imagine you’re playing this game. You’re one of the normal people, you hand your dollar over, you win some, you lose some.
But if you lose a couple in a row, you can see the thought of, you know, maybe I’ll just keep my dollar in my pocket here, sit out a couple of rounds and then I’ll come back when I’m feeling better.
And you can see how that is true when it comes to investing in the stock market as well.
When you’re doing well, you want to keep handing your money over because, “I’m feeling really good about things.”
But if you’ve lost for some time, you might say to yourself, “You know what, I’m perfectly happy to put this cash in my pocket and sort of sit out for some time.”
Mixing emotions and investing
People with certain kinds of brain damage may make better investment decisions, as we saw in the study we just talked about.
However, normal thinking people like you and me mix emotions with investing (fear of losses and pleasure of gains) that can lead to bad outcomes.
The above-mentioned study suggests that the participants’ lack of emotional responsiveness actually gave them an advantage when they played a simple investment game. The emotionally impaired players were more willing to take gambles that had high payoffs because they lacked fear.
On the other hand, players with undamaged brain wiring were more cautious and reactive during the game, and wound up with less money at the end.
Scientists suggest – “Good investors can learn to control their emotions in certain ways to become like those people.”
In other words, you can become a better investor by getting your brain damaged in such a way that you lose your emotions while keeping your logic and cognitive reasoning unaffected.
What say you?
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