Given the market’s recent volatility and the fear it can engender, it’s probably a good time to revisit what we know about investing and the psychology of fear. Fortunately, this is a rich area of study with a consistent conclusion: Our rapid fear response may have once been critical to human survival but serves us poorly when making financial decisions. A 2004 study led by Stanford University professor and neuroeconomics expert Baba Shiv provided a fascinating example of this finding.
Shiv and his team began by endowing each study participant with $20, then offered them a chance to “invest” a dollar on the flip of a coin. If the coin landed on heads, the “investor” was paid $2.50. If the flip landed on tails, the investor lost their dollar. The game lasted 20 rounds, and before each round the player was given a chance to decide whether to continue to participate. Even though the game involves a random outcome with a 50% chance of success, the asymmetric payoff structure makes this a very attractive situation. In fact, if you do the math, there’s not only a significant positive expected return for each round, but just a 13% chance a player will end up with less than they started with if they invest in all 20 rounds.
Despite these favorable odds, participants chose to invest in just 57% of the rounds. Further, participants were far less likely to invest if the previous outcome was a loss, even though each coin flip was independent. Because Shiv and his team theorized that subjects were unlikely to play the game optimally due largely to the fear of sustaining a loss, they then offered the game to a new set of participants. Members of this new group suffered from a very specific form of brain damage, leaving them largely incapable of feeling fear. These “fearless” participants invested more frequently than previous participants and were unaffected by previous outcomes, consistently choosing to invest about 84% of the time. Of course, this is just one of many studies that document the central role played by emotions when making decisions in uncertain situations. But this one stands out to me as unique, given its focus on isolating the fear response and demonstrating that a lack of emotional response can lead to better outcomes in some situations.
I also like this study because the parallels between the game it uses and the stock market are quite straightforward. No, there’s no coin flipping involved, but historically the path and timing of stock returns have been uncertain, though very attractive. Even in the current environment, we continue to believe that owning businesses in the form of common stock offers not only the expectation of a positive return but remains a compelling opportunity over the long term. And like all opportunities that reward prudent risk taking, the ability to limit one’s fear response is critical to success.