DOING Better vs. FEELING Better

Apr 2010 //
Optimism/Pessimism
Investing
Behavioral Finance

. . . a group of test subjects was given 20 one-dollar bills and offered 20 chances to bet on a coin flip.  If the coin landed heads, the subjects received $2.50, and if it landed tails, they lost their $1 bet.  This is a great deal, because over 20 bets, the most likely outcome is for subjects to earn $15—in addition to their original $20.  That’s a 75% return. It turns out that virtually all test subjects accepted the bet for the first five plays.  Statistically speaking, the odds were that each participant would win two or three of the first five coin flips.  However, chance being what it is, some participants won—or lost—four or five of the first five plays.  Despite the clear 50/50 nature of the bets, those subjects who lost four or five times subsequently became reluctant to play as often going forward as those who had better initial outcomes.  That’s the way it is with investing, too.  Investors who experience unexpectedly disappointing results will sometimes decide to stop investing, even though they may acknowledge, intellec­tually, that their future prospects for investing success are as good as ever.  Indeed, because the low stock prices that follow bear markets often set the stage for above-average returns in the next bull market, in the investing arena, the odds for success actually improve after bear markets.  However, with the memory of investment pain fresh in their minds, some investors will pursue inferior investment alternatives in an attempt to feel better.  For feeling better, there are lots of choices.  For doing better, there typically aren’t.