Globe Investor Magazine, Nov. 21, 2007
WALK INTO A GAMBLING EMPORIUM anywhere in the world and you're apt to see a grim bettor, sweat dripping from his forehead, frantically increasing his wagers in a desperate effort to recoup mounting losses. The outcome is usually predictable: The hapless gambler continues to place losing bets until the money and credit are completely gone.
The odds are better in the markets than at the roulette table, but many investors make similar mistakes. Fortunately, when times are good and investments in everything from stocks, bonds and currencies to real estate and commodities are going in only one direction, the environment helps compensate. But the same errors of judgment can-and do-lead to misery and ruin in more tempestuous times, when forecasts go awry, risks rise sharply and pessimism runs rampant.
At times like these, what drives people to irrational behaviour? Why do they in--crease their bets the more they lose? Scientists blame the workings of the human brain-under duress, we tune out our rational thought processes and cede control over our decisions to a part of the cerebellum originally wired to fend off mammoths and sabre-toothed tigers. It's probably not necessary to point out that, so far, paleoanthropologists haven't found any decent investment planning advice painted on the walls of a cave.
Scientists can also explain why so many of us love to gamble in the first place, whether in the markets or at the card table: The release of a feel-good neurotransmitter called dopamine appears to be triggered by both increased risk and random reward-two components supplied in ample quantity by casinos and stock markets. Simply put, taking risks feels good, while keeping money in cautious investments with steady but modest annual returns doesn't boost anybody's dopamine buzz.
Psychologists say these problems are compounded by the human needs for consistency and social acceptance. How can we abandon bad investments if we believe they're integral parts of our in--vestment strategies-or if we've personally recommended them to others? We're also naturally inclined to ignore information that casts doubt on our decisions, while embracing the slightest fact that supports them.
These factors mean that in stressful periods emotion and primitive thought processes begin to take over and even professional traders may toss out carefully designed strategies and pursue short-term gains at the expense of long-term investing goals. Their biggest mistakes show up when they abandon the first rule of Investing 101 and cash out of winning investments too early-yet cling stubbornly to money-losers in declining markets. They forget the old rule of knowing when to get out before getting in-and worse, compound their miseries by pouring increasing amounts of money into the losing positions.
"This is the way most people go bankrupt," says Arthur Heinmaa, managing partner with Toronto Capital Markets in Toronto, who's seen it all in his years on the Street and still marvels at the predictable patterns that unfold when markets change direction. "They're fast to take $1 gains and yet they take $20 losses. What happens is that their gains are very, very small in relation to their losses."
That's when the math inexorably turns against a gambler-or an investor. A skilled and disciplined trader can turn a handsome profit by being right on as few as one out of three investments, regardless of whether markets are moving up or down. The key is to ride the successes and jettison the stinkers. Competent traders score perhaps 60% or 70% of the time; if they hope to make consistent profits, they can ill-afford to lose even $2 on the bad bets for every dollar they make on the good ones. Yet many players routinely pile up losses of $5 or more for every dollar gained, which means they have to guess right at least 90% of the time just to break even.
Why are these bad habits so hard to break? Adrienne Toghraie, who has built a lucrative business helping traders overcome such counterproductive behaviour, has a simple if colourful explanation of the psychology at play when people visit that well-known stock market shrine, Our Lady of the Perpetual Loss. "Anything bad that's ever happened to you has to do with a loss," she says. "When you have a loss or a series of losses, you go into that [mental] place where all of the losses have occurred."
Toghraie calls that place "the cesspool"--a mental pit of everything bad that's ever happened since childhood-and traders stuck there trade from emotion, rather than relying on systems or techniques that have made them money in the past.
But the solution is not, as one might think, to ignore emotion. In fact, some experts say emotion has a vital role to play in investing, drawing encouragement from new academic research that suggests people make better decisions-and get higher returns-when they have more in tense feelings invested in them.
The real question isn't whether emotions should be suppressed in the interests of cold, hard logic, but whether they can be placed in the service of sensible strategies. Still, until some scientific genius figures out how to rewire the brains of ordinary investors, the best any-one can do is shelter his or her emotions under the umbrella of common sense - and wait out the market's storms. - BRIAN MILNER
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