4 reasons people make bad investment choices

Fear of loss may turn you into the biggest loser

By Cass R. Sunstein

Apr 10, 2014 @ 5:22 pm EST

Bloomberg News

For many years, I have studied human behavior, including the mistakes occasionally made by fallible people, including investors.

But a few years ago, I made a really dumb investment decision. In a single day, I hit the trifecta, committing at least three classic behavioral mistakes.

The year was 2011. The stock market was recovering well from its terrible collapse during the Great Recession, but over a short period it had a series of stumbles. I got nervous. What if it collapsed again?

At the time, I was working in the federal government, with a daughter in college, a 2-year-old boy and a new child on the way. Could I afford to lose a lot of money? Wouldn't it make sense to sell equities and to put the money into a safe, reliable certificate of deposit?

Economists know that if you invest in stocks, it makes sense to choose passively managed, highly diversified index funds. I had done exactly that. But seeing a decline in the fund's value, I decided to sell a significant chunk. I e-mailed Richard Thaler, the great behavioral economist and my co-author on "Nudge," and before proceeding, I asked him whether I would be making a mistake.

His response: “Reread our book!”

I pretty much knew what he meant, but that was a bit vague for me (our book is long), so I proceeded as planned and sold that significant chunk. Giving Mr. Thaler the news, he exclaimed, “No! 'Nudge' explains that you shouldn't have done that!”

The fund is now up about 66 percent from the date I sold it. It looks as if Mr. Thaler was right. In fact, a little voice in my head told me, even at the time, that I was acting rashly.

Of the behavioral mistakes to which I fell victim, the first is called “availability bias.” Behavioral scientists have shown that if something has happened in the recent past, it is cognitively “available,” and people tend to exaggerate the probability that it will happen in the future.

Availability bias isn't exactly irrational, but it can produce big mistakes. The stock market did collapse in 2008, but it doesn't collapse very often, and in 2011 I shouldn't have focused on the risk of another meltdown.

The second mistake involves "loss aversion." People tend to hate losses from the status quo - in fact, they hate them far more than they like equivalent gains. If you suddenly lose $10,000, the distress you would feel would almost certainly be greater than the joy you would feel if you suddenly gained $10,000.

The irony is that if we make our decisions on the basis of loss aversion, we'll end up as big losers. A case in point: As the stock market started to fall, I wanted to prevent losses, and as a result, I lost a lot.

The third bias is called "probability neglect." Human beings tend to focus on worst-case scenarios, especially when their emotions are running high, and not on the likelihood that such scenarios will actually come about. When I made my stupid decision, the worst-case scenario (another collapse!) loomed large. I devoted far too little attention to the question of whether it was probable.

Behavioral economists now have a detailed account of the biases to which investors are subject. For example, they are also prone to the “disposition effect,” which means that they sell stocks too quickly when they have appreciated in price while holding on too long to stocks that have depreciated in price.

In addition, a lot of individual investors are overconfident. (Men are worse than women on this count.) They like to buy, and they like to sell, and they think that they can work some magic to make a lot of money. Forget about it. The stock market isn't a Steven Spielberg movie.

It cannot be said too often that the best advice, for most people, is boring and simple, so here's a nudge: Have a diversified portfolio, consisting in large part of low-cost index funds, weighted toward equities; add money as you get it, and diversify it as well; keep the cash you need; and otherwise hold steady (and spend a lot of time with the sports pages).

If your emotions start to get the better of you, and you think it's time to make a big move in a significantly different direction, it's good to have Thaler's voice in your head, saying a single, beautiful word: "No."

Cass R. Sunstein, the Robert Walmsley university professor at Harvard Law School, is a Bloomberg View columnist. He is the author of two new books, "Why Nudge?" and "Conspiracy Theories and Other Dangerous Ideas," and is a former administrator of the White House Office of Information and Regulatory Affairs. Follow him on Twitter at @CassSunstein.

(Bloomberg News)

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