Executive Education: Personal Investment Decisions and the Irrational Lack of Exuberance
By Mark Wheeler, Ph.D.
DSI Consultant
How do you respond to risk and uncertainty when you make personal financial decisions? Just as businesses are required to make choices about the future based upon uncertain expectations and incomplete information, individuals must also make emotionally-charged financial decisions under conditions of considerable ambiguity. They need to address complex questions such as: (1) How much of my income should I spend, and how much should I invest? (2) What will happen to the stock market? (3) How much money will I need (or want) in twenty years? and (4) How will I feel if I lose money from my investments?
Over the next 20 years, there will be a dramatic increase in the number of critical financial choices that Americans will be required to make for themselves. The number of American households owning mutual funds is steadily rising, from 51.7 million in 2000 to 53.3 million in 2003. With the decline of traditional pension plans and the surging popularity of individual retirement options such as 401(k) and 403(b) plans, people are now commonly asked to make choices that will profoundly affect their future income streams. These important choices are often made after only minimal thought and reflection, typically as part of an employee orientation seminar.
In addition, the transfer of wealth via inheritance will present millions of Americans with financial windfalls, and difficult investment and spending decisions. The intergenerational wealth transfer in the United States between 1998 and 2052 has been estimated between $41 trillion and $134 trillion.1 The choices that inheritors make with their new wealth will affect not only the lives of the inheritors themselves, but the entire national economy.
Risk Aversion and Financial Decision Making
There is a considerable body of research describing the ways that people make financial decisions and how to improve them. It is now quite clear that when people consider their financial options, they are prone to a number of decision mistakes. Fortunately, these mistakes are predictable and thus can be prepared for. For example, much has been discovered about the influences of decision framing – the way that different options are presented. By simply changing the wording of a choice, people will make different decisions. Below is a brief example of a common financial decision mistake, and the way that changing the framing of the decision could help an investor to overcome the mistake.
As all financial planners and advisors are aware, many individual investors shy away from risky investments, and prefer to keep their money in relatively conservative places such as money markets, treasury bills, and high quality bond funds. The rationale for such choices is obvious – people are afraid to take chances with their money for fear of losing it in a market downturn. There is nothing generally wrong with such caution, but money parked in “safe” places for extended time periods is blocked from earning the kind of high cumulative, yet variable, returns enjoyed by investments in common stock and stock mutual funds. Tens of millions of Americans have most or all of their retirement funds or other investment monies in CD’s, money markets and treasury bills. Over many years, these investors have sacrificed huge amounts of income because of their short-term risk aversion. Given the historical trajectory of the stock market, they would not have taken much risk by buying and holding stocks or stock mutual funds for the long term.
Research on Risk Aversion
This common, and largely irrational, form of risk-aversion has been well-studied. Risk-aversion is most likely to occur when people frame their investment choices in particular ways. Consider the following experiment conducted by two of the most prominent researchers in decision-making, Daniel Kahneman and Amos Tversky.2 The researchers asked a number of people to make either financial Choice #1 or Choice #2
Choice #1: Imagine that you have been given $1000. Now choose between: Option A: a 50% chance to gain another $1000, or Option B: a sure gain of another $500 (Given this choice, 84% of people chose Option B)
Choice #2: Imagine that you have been given $2000. Now choose between: Option A: a 50% chance of losing $1000, or Option B: a sure loss of $500 (Given this choice, 31% of people chose Option B)
Looking at the choices together, it is clear that they are identical. In both cases, people decide whether to take a sure $1500, or gamble for the possibility of $2000 with the chance to receive only $1000. In many demonstrations, Kahneman and Tversky have shown that when people think about what they stand to gain, they become averse to risk. Investors are often happy to receive small, sure gains, and are then reluctant to gamble the small gains for additional, uncertain gains. Yet when people think about what they might lose, they become risk-seeking. People hate to lose any part of their initial investment (as illustrated in Choice #2), and are often willing to risk an even bigger loss to try to prevent the initial loss.
This demonstration provides a strong foundation for understanding why many people are irrationally risk-averse with their money. Even though future retirement income should be framed in terms of long-term gain, many investors are satisfied with the promise of a small, sure gain, and refuse to simply average out the quarterly fluctuations. The financial risks of buying stocks are (over the long-term) quite small, and the reward of stocks is quite high.
Focusing on the Downside
When long-term investment choices are re-framed (as could be done by a financial planner or advisor), decisions about personal finance change dramatically. For any financial planner or advisor dealing with an irrationally risk-averse client, the best strategy is one that may seem paradoxical: reframe the investment decision in terms of what the client has to lose.
Rather than stressing to potential to gain a very strong return with stocks or stock funds, it is helpful to stress the lost opportunity in investment portfolios that play it very safe. Because people hate to lose money (or time, or opportunities), a decision frame that emphasizes a nearly certain loss of future income (through overly safe investing) will induce investors to put more of their assets into stocks or other securities with greater long-term returns.
DSI and Behavioral Decision Making
Myopic risk-aversion is only one of many common decision traps individual decision makers fall into. The practice of framing and re-framing financial or other choices could be valuable to financial planners or others who advise individuals about their finances. DSI now offers continuing education and executive education courses on this and similar topics. An up-to-date managerial review of the fascinating new field of behavioral decision theory is offered in a book that DSI Chairman Paul Schoemaker co-authored with Prof. J. Edward Russo titled Winning Decisions: How To Get It Right the First Time (Doubleday, 2002). This book builds on their earlier book Decision Traps which has sold over 100,000 copies, published in many languages, around the world.
Notes
1Schervish, P.G., & Havens, J. J. (October 1999). Millionaires and the Millennium: New Estimates of the Forthcoming Wealth Transfer and the Prospects for a Golden Age of Philanthropy http://www.bc.edu/research/swri/meta-elements/pdf/m_m.pdf
2Kahneman, D., & Tversky, A. (1979). Prospect theory: An analysis of decision under risk. Econometrica, 47, 363-391.
