People, it’s increasingly apparent, buy, sell, and invest not like computers but like, well, imperfect people. ‘‘People are not stu- pid,’’ says another psychology-savvy behavioral economist, Robert Shiller, ‘‘but they have their limitations.’’ When following our in- stincts we make decisions mostly swiftly, often smartly, but some- times stupidly. Economic intuition sometimes defies economic logic. Consider five illustrative anomalies.
Loss aversion. You’re about to buy that car, for which you need
you rather sell $20,000 of your GE shares, for which you paid $10,000, or $20,000 of your AT&T shares, for which you paid $30,000?
Terrance Odean’s analysis of trading records for 10,000 accounts at a large discount brokerage shows that most people strongly prefer to ‘‘lock in’’ a profit rather than absorb a loss. Said differently, they prefer to sell the winner and hang on to the loser (or as Peter Lynch has said, to pull up the flowers and water the weeds). There’s no logically right answer here—no investor knows the future value of either stock. But the preference is curious, given that, rationally, an investor’s goal is to make money, not redeem past mistakes. Whether one has made or lost money to this point is irrelevant (if anything, tax considerations would favor selling the loser for a tax loss and avoid- ing the capital gains tax on the winner). Yet our aversion to loss deters us from locking in the loss, which becomes real and final—not just a paper loss—the moment we sell.
That’s understandable psychologically if not logically, Kahneman and Tversky’s studies show, because we derive more pain from losing than pleasure from gaining. We’re therefore conservative when given a chance to lock in a win, but daring when given a chance to avoid loss. In experiments, people prefer a sure gain over flipping a coin for double or nothing. Yet they will readily flip a coin on a double or nothing chance to avert a loss. In fact, Kahneman and Tversky report, we feel the pain from a loss twice as keenly as we feel the pleasure from a similar-sized gain.
Our aversion to loss is readily apparent outside the laboratory as well:
≤ Hoping to wipe out losses, gamblers will bet on longer odds at the day’s end.
≤ Given that only 60 cents or so of every insurance premium gets returned to insureds to cover losses (the rest funds the system), upstanding insurance agents must educate people to elect large deductibles and not to insure against small, affordable losses. In the long run, insurance companies profit from our aversion to loss. The same aversion motivates some people to buy ser- vice contracts that insure against appliance breakdowns, but for greater long-term costs.
≤ Your basketball team is behind by two points with time only for one last shot. Would you prefer a two-point or a three-point at- tempt? Many coaches, intuitively preferring to avoid loss, seek to put the game into overtime with a two-point shot. After all, an average three-point shot will produce a win only one-third of the time. But if that same team averages 50 percent of its two-point attempts, they have about a 50 percent chance of overtime—where, judging from the game to this point, the out- come is a toss-up. That yields only a 25 percent chance of a) an overtime followed by b) a victory.
The endowment effect. Would you trade lives with your next-door
neighbor? Would you trade houses (or apartments)? Cars? Jobs? Noses? Unless you’re depressed, you probably prefer the life and things you have to most alternatives. In economic terms, people often demand much more to give up something than they’re willing to pay to acquire it. Economist Thaler has labeled this phenomenon the endowment effect.
In one study, the experimenters gave some people $2 and others a lottery ticket of equal value. Later, when they offered everyone a chance to trade, most preferred to keep whichever they had. In sev- eral other studies, researchers gave Cornell students coffee mugs and not long after asked them the lowest price they would sell it for. This sell price averaged more than three times what students not given the mugs said they would pay to buy one. Ownership creates inertia. Take home that home entertainment system on a money-back trial period, and you will likely never return it. As owners, we place a greater value on things simply because they’re ours. Many music fans who wouldn’t pay more than $30 for a particular concert ticket wouldn’t sell one they own for less than $50.
The endowment effect is a corollary of loss aversion. We hate to lose what we have. Hoping to wipe out losses, and feeling the attach- ment that accompanies ownership, investors will therefore throw good money after bad. Loss aversion and the endowment effect to- gether feed our hesitation to abandon failing projects in which ‘‘too much is invested to quit.’’ In experiments, as in real life, people who have made a considerable investment in a failing project prefer to
continue investing resources, even when they’d never invest if consid- ering this as a new investment on its own merits and even when abandoning the effort is economically rational.
As investor for a family foundation, this is a phenomenon I know painfully well. Understanding the perils of our economic intuition helps. But understanding does not guarantee optimal rationality. Re- flecting on his lifetime’s research on why smart people make dumb decisions, Amos Tversky reflected that ‘‘all our problems fooled us, too.’’ As powerful perceptual illusions fool those who study them, so compelling economic illusions can trip those who should know better.
The sunk cost effect. Put yourself in the participants’ shoes in an-
other of Kahneman and Tversky’s experiments: Imagine that you have decided to see a play where admission is $20 per ticket. As you approach the theater you discover that you have lost a $20 bill. Would you still pay $20 for a ticket to the play?
Surely you would join the 88 percent of their participants who answered yes. Most others, however, when asked to imagine that they’d lost the $20 ticket, said they would not pay $20 for another ticket (because the play wasn’t worth $40). Rationally, the $20 is a ‘‘sunk cost.’’ It’s gone, whether in the form of a ticket or a lost bill. So, looking to the future, the question is simply whether the play is still worth $20.
A similar sunk cost anomaly surfaced when Hal Arkes and Cather- ine Blumer invited Ohio University students to imagine buying a Michigan weekend ski trip ticket for $100, and later buying a ticket for an even more appealing Wisconsin skip trip ticket for just $50. On discovering that the two trips are the same weekend, Arkes and Blumer asked, ‘‘Which ski trip would you go on?’’ Most, not wanting to waste the larger sunk cost, said they’d go on the trip they would enjoy less.
Sunk costs also help explain the ‘‘too much invested to quit’’ phe- nomenon. The Ford Motor Company erred in bringing the Edsel to market in the late 1950s at a sunk cost of $250 million and then—not wanting the sunk cost to become a locked-in loss—compounded the error by continuing production for two and a half more years at an additional $200 million.
anew, the United States would never have begun it. With so much invested, in lives and money lost, it was hard to quit. Said Secretary of Defense Robert McNamara, ‘‘We could not simply walk away from an enterprise involving two administrations, five allied countries, and thirty-one thousand dead as if we were switching off a television channel.’’
Government spending on unworkable defense and public works projects has likewise continued because their termination would presumably waste monies already spent. Responding to critics who pointed out that the value of a completed Tennessee-Tombigbee Wa- terway Project would be less than the money needed to complete it, Senator Jeremiah Denton argued that ‘‘to terminate a project in which $1.1 billion has been invested represents an unconscionable mishandling of taxpayers’ dollars.’’
The moral: The past is over. Learn from it. But when making deci- sions, remember that each day is indeed the first day of your future. Don’t look back. ‘‘If we could, we’d send you a pill that erases the memory of every dollar you ever spent,’’ say tongue-in-cheek Gary Belsky and Thomas Gilovich in Why Smart People Make Big Money
Mistakes. ‘‘That’s because once spent, it’s gone. It has no relevance.’’
Ergo, don’t let sunk costs affect future decisions. Base decisions on the present, with an eye to the future.
Anchoring. Would you say the Mississippi River is more or less than
800 miles long? How long would you guess it is?
When estimating the river’s length (which is 2,348 miles), arbi- trary comparison numbers (‘‘anchors’’) readily influence people’s judgments. If I had first asked whether the river was more or less than 5,000 miles long, you would surely have said ‘‘less’’ but likely would have given a higher estimate than you just did.
Tversky and Kahneman later made the comparison number seem random, by spinning a wheel with numbers from one to a hundred. Still, people estimated about 25 percent of United Nations countries were African after the wheel was rigged to stop at ten, and 45 percent after the wheel stopped at sixty-five. (The correct answer at the time was 32 percent.) Given even these meaningless anchors, people cali- brated their answers from that starting point.
well. The Nasdaq’s exuberant high-water mark, 5,132, forms a mis- leading comparison point for intuiting its realistic value today. Indi- vidual company stocks, too, can seem cheap if they’re at half their previous high, and pricey if they’ve recently doubled. My aunt, who bought Microsoft when it went public in 1986 and has held it ever since, is glad she never judged it as overvalued relative to the anchor point of its first week’s price (20 cents, adjusted for later splits).
Financial writer Belsky and social psychologist Gilovich recount Gregory Northcraft and Margaret Neale’s clever 1987 experiment with experienced Tucson real estate agents. After touring a home and receiving a ten-page information packet indicating a $65,900 list price, agents offered an average appraisal of $67,811. Others went on the same tour and received the same information, except with an $83,900 listing. Their average appraisal: $75,190.
I can imagine real estate agents exploiting the anchoring effect by asking their clients, ‘‘Would you guess this house is listed at more or less than $250,000?’’ ‘‘Less, I’d hope.’’ ‘‘How much would you guess?’’ ‘‘$230,000?’’ ‘‘No—only $219,000!’’
Overconfidence. Overconfidence, as we noted in earlier chapters,
routinely appears in our judgments of our past knowledge (‘‘I knew it all along’’), in our current knowledge (overestimating the accuracy of our factual judgments), and in predictions of our future behaviors, successes, and completion times (illusory optimism). Overconfidence also infuses economic intuition. Financial forecasts, for example, are consistently too optimistic:
≤ In 1984, The Economist asked four European former finance ministers, four chairs of multinational firms, four Oxford stu- dents, and four London garbage collectors to predict the next decade’s inflation, growth rates, and sterling exchange rates. Adding up scores ten years later, the garbage haulers tied the company bosses for first place, and the finance ministers fin- ished last.
≤ Ronald Reagan and his advisors were very confident (and very wrong) that economic growth stimulated by their massive tax cut would increase government revenues and decrease the defi- cit.
≤ Most start-up business plans are overly if not wildly optimistic about future success.
≤ Most industrial firms overestimate their future production. ≤ Wall Street analysts predicted that the companies in Standard
& Poor’s 500 index would average 21.9 percent earnings growth per year between 1982 and 1997. Despite the growing economy, reality (7.6 percent annual earnings growth) was barely one- third their estimates.
≤ Analysts’ unrelenting optimism also appears in their buy and sell recommendations. Of the 8,000 analyst recommendations on S&P 500 stock companies at the end of 2000, only 29 recom- mended selling.
Overconfidence is greatest for the most unpredictable events. As we might expect, then, nowhere is overconfidence so abundant as in the stock market’s recent hyperactivity. Each day about 2 billion shares exchange between buyers, who feel some confidence that a stock will rise, and sellers, who feel some confidence that it will not. Alas, as in Las Vegas, the only consistent winners in this game, which is near zero-sum on most days, are those who collect the trading costs and taxes. People who actively trade, notes Yale’s endowment man- ager, David Swenson, ‘‘lose to the market by the amount it costs to play, in the form of management fees, trading commissions, and dealer spread. Wall Street’s share of the pie defines the amount of performance drag experienced by the would-be market beaters.’’
Brad Barber and Terrance Odean, University of California–Davis researchers, analyzed trades by 66,465 discount broker accounts from 1991 to 1996. Those who, bullish on their prognostications, traded the most, earned 11.4 percent annually while the market re- turned 17.9 percent. Clearly, say Barber and Odean, emphasizing the perils of investment intuition, ‘‘investors trade too much and to their detriment.’’
In a follow-up study of data from 35,000 broker accounts, they found that ‘‘men are more overconfident than women.’’ They traded 45 percent more often, earning results that underperformed the mar- ket by 2.65 percent (54 percent more than women’s 1.72 percent un- derperformance). This confirms earlier findings that men rely less on
brokers and anticipate higher returns than do women. In stock trad- ing as in other realms, men make more self-serving attributions—by taking credit for their successes (‘‘I had a feeling’’) and explaining away failures (‘‘Were it not for the strike . . . the interest rate increase . . . the slowdown’’).
It doesn’t take such fine-grained analysis to see psychological fac- tors at work in what Federal Reserve Board chairman Alan Greenspan called the ‘‘irrational exuberance’’ of the late 1990s stock market bub- ble, and what some saw as the ‘‘irrational pessimism’’ after the bubble burst. Traders, like wolves, run in packs. ‘‘Momentum investing’’ creates self-fulfilling prophecies—times during which investors buy not because opportunities are undervalued but because prices are rising. ‘‘Everyone’s Getting Rich in Tech: Here’s How To Get Your Share,’’ declared the cover of the May 1999 issue of Money magazine. Before long, the same herd will frantically sell when prices are falling. In the short run, momentum investing can feed an upward spiral. As traders tell of their windfalls, others are enticed—who wants to miss out on the boom with cash that’s gathering dust in a bond fund? Mutual funds that have bought the booming stocks attract investor dollars, which are then poured into more of the same stocks, driving their prices higher. Moreover, the media fan the exuberance with anecdotes and with theories of how a ‘‘new economy’’ justifies sky-high valuations. (Economist Burton Malkiel noted, just as the Nasdaq bubble began to deflate, that if Cisco Systems was to produce a 15 percent return to investors for the next twenty years its market capitalization would exceed the current gross domestic product.)
But as happened with Holland’s seventeenth-century tulip mania, reality eventually reasserts itself. Stocks are ultimately worth only the value of the cash flow they earn for their investors. When prices begin falling, analysts change their tune. Speaking with the wisdom of hindsight, a chorus of voices then tells us that the market was ‘‘due for a correction.’’ After the April 2000 week in which the Nasdaq fell 25 percent, one New York Times article quoted gloomy analysts:
‘‘By most measures, technology stocks have been in a bubble for years. . . . Friday’s plunge was needed to wring excesses out of stock prices.’’
‘‘Despite sharp declines, technology stocks are still overvalued, and many conservative investors will not be interested in buying them until they fall much lower.’’
‘‘People are panicking and getting out at all costs. This thing could get a lot uglier.’’
‘‘Investors who buy too soon may ‘catch a falling knife.’ ’’
When prices fell further, after the terrorist attacks of September 11, 2001, Malkiel warned that yesterday’s irrational exuberance was in danger of becoming today’s ‘‘unreasoned anxiety.’’
Noting how small bits of good news turn the chatter bullish and send stocks soaring, and how minor bad news does the opposite, reminds me of my own studies of ‘‘group polarization.’’ Groups am- plify their shared tendencies. In one study, we observed that when prejudiced high school students discussed racial issues, their atti- tudes became more prejudiced. When low-prejudice students dis- cussed the same issues, they became more tolerant.
Group polarization can amplify a sought-after spiritual awareness and strengthen the mutual resolve of those in a self-help group. But it can also have dire consequences. In experiments, group decision making amplifies retaliatory responses to provocation. In the real world, terrorism arises among people who are drawn together out of a shared grievance and who become more and more extreme as they interact in isolation from moderating influences. In the marketplace, people who are lusting for gain or fearing loss feed off one another— amplifying their optimism, at one moment, and their pessimism, at another. The natural result is overreaction—irrational exuberance and irrational panic.