Mr. Spock, the fictional Vulcan character on TV's original Star Trek, was famous for his cold logic and lack of emotion. Until recently, many investment experts treated investors as if they were from Vulcan rather than human beings. Indeed, a key pillar of investment portfolio theory was the belief that individuals clearly understood their own preferences and motivations and made choices based on a rational evaluation of their options.
But it was not until Daniel Kahneman's Nobel-Prize winning work in the late 1970s that economists started to question some of the portfolio theory "pillars." Dr. Kahneman's focus, behavioural economics, was on the biases and "rules of thumb" that people used – often in direct violation of some of these pillars. In one experiment, Dr. Kahneman offered subjects the choice between (i) a guaranteed $3,000 or (ii) an 80 per cent chance of winning $4,000 and 20 per cent chance of winning $0.
Note that in the second option, the subject's probability-weighted outcome is $3,200. Despite the higher potential return of the second option, the majority of subjects chose the guaranteed option, contrary to what theorists had previously predicted.
Dr. Kahneman proved that most people would choose the first option – preferring to give up a potential extra $200 for the guaranteed outcome. He referred to this as "loss aversion" and showed that this was not irrational – in fact, it is a practical application of the old saying "a bird in the hand is worth two in the bush".
Dr. Kahneman's revolutionary work broadened our understanding of investment portfolio theory and revealed that people's rational evaluation of a choice includes the potential economic benefits, as well as the emotional benefits, of that choice. Moreover, factoring that potential emotional benefit into the decision-making process, in particular the avoidance of regret is very rational.
A tragic example of the consequences of regret occurred in April, 1995, in Britain when a man took his own life because he neglected to play his regular lottery numbers on the day those numbers won the £2-million lottery prize. Regret is different from other emotions in a number of ways – first, it is a learned emotion. Research shows that while five-year-olds can experience other emotions, regret does not seem to be experienced until the age of 7. Secondly, regret is a "thinking" emotion – you have to think about the decision you made, the option that you gave up and how things might have turned out if you had chosen it instead, and compare the two outcomes for regret to manifest itself.
Regret serves a purpose. It forces you to evaluate how you made a decision and what you learned from the outcome that you will apply in future situations.
In the Kahneman experiment above, it is likely that those who chose the certain $3,000 had experienced regret (or could anticipate the regret they would feel) of having chosen the riskier option only to end up with nothing. Accounting for future regret in decision-making is not irrational.
But, regret can also be counter-productive, particularly when it comes to investing.
In a 2005 paper, "Investment Behaviour and the Negative Side of Emotion," researchers investigated how participants with brain lesions in areas related to emotion ("target" patients) made 20 rounds of investment decisions compared to "normal" patients without such lesions. The researchers found that the target patients made more advantageous decisions and ultimately earned more money than normal patients. Normal patients appeared to be more affected by outcomes of decisions in previous rounds so they adopted a more conservative strategy in subsequent rounds. The researchers concluded that emotions, our bodies' mechanism to kick-start our prehistoric fight-or-flight instincts, play a central role in risk-taking behaviour.
So while none of us may aspire to be Spock-like in our approach to life, learning to control our inner caveman (or cavewoman) may be the key to investing success.
Sam Sivarajan is managing director and head of investments with Manulife Private Wealth.