ood on judg-ment. Subjects in a positive emotional state tend to reduce the complexityof decisions by adopting a simpler process of information retrieval. Happi-ness is associated with the greater use of cognitive heuristics (“shortcuts”)such as stereotypes.8 Positive people disregard irrelevant information, con-sider fewer dimensions, recheck less information, and take signiﬁcantlyless time to make a choice than people who are feeling negative.9,10
During ﬁnancial gambles, positive people choose differently than neg-ative ones. When stakes are high, people in positive emotional states tryto maintain their positive state and avoid substantial losses.11 In contrast,if stakes are low, joyful decision makers become risk seeking in order tobeneﬁt from the gain (though without wagering so much as to risk theirhappiness). In terms of behavior, happy people act to avoid the possibil-ity of a large loss in order to protect their positive emotional state.12 Sowhile happy people make more optimistic judgments, in situations wherethey foresee a reasonable likelihood of large losses, they avoid takingrisk.
While positive emotions broaden one’s focus, negative emotionsnarrow it.13 Negative moods are associated with a more ruminative andvigilant (hyperalert) thought process.14 Negative emotions predispose toexcessive risk perception and overreaction to losses.
Professor Paul Slovic and colleagues at the Center for Decision Re-search measured subjects’ personality propensities, either as “negativelyreactive” or “positively reactive.” They then asked these subjects to play amodiﬁed Iowa Gambling Task (IGT; see Chapter 2 for description). Slovicfound that participants high in negative reactivity learned to choose fewerhigh-loss options (perhaps because they are more sensitive to loss), whilethose high in positive reactivity learned to choose more high-gain options.These characteristic choice behaviors led to less overall proﬁt for positivepeople playing the IGT.
Table 6.2 provides a summary and comparison of positive and negative
emotions on decision making, judgment, and behavior.
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TABLE 6.2 Positive and Negative Emotion’s Eﬀects on Thought
People in a Positive Mood
People in a Negative Mood
Reduce the complexity of the
Detail-oriented.
decisions.
Adopt a simpler process ofinformation retrieval.
Vigilant and broad analysis.
Disregard irrelevant information.Consider fewer dimensions.Recheck less information.Take signiﬁcantly less time to make
Often excessively focused on minutiae.Broad observations.Repeat and double-check.Slow and thoughtful, occasional “analysis
a choice.
paralysis.”
Take more risk in low-stakes
Avoid small risks when possible.
gambles.
Take less risk in high-stakes
gambles.
More likely to spend excessive amountsof money on large purchases or riskybets.
Less reﬂective after a failure; more
Ruminate about setbacks and have more
resilient after losses.
trouble getting back on their feet.
REGRET AS A SELF-FULFILLING PROPHECY
Regret is an uncomfortable but intrinsic part of investing. Inevitably, somedecisions are bound to go wrong, leading to losses. Those who can’t“take a loss” objectively will experience regret. It is very experienced in-vestors who can be detached from the emotional impacts of large losses.It is regret’s discomfort that drives two of the most common behavioralbiases.
In behavioral ﬁnance research, one of the most prevalent biases is thetendency to hold losing stocks longer than winning stocks. That is, mostinvestors too frequently “let their losers run and cut their winners short.”This is called the disposition effect (discussed in detail in Chapters 14 and15). Many academics believe that the disposition effect is due to the “fearof regret.”
Selling a losing stock is tantamount to admitting that one was wrong.Feeling wrong inspires painful regret. To avoid regret, investors hold on tolosing stocks while hoping for a comeback that will vindicate their initialbuy decision.
They sell winning stocks too soon because they fear that the stock willdrop, giving back their gains, and they will regret not having taken theirpaper proﬁts off the table while they had the chance. So whether one’s
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stocks are up or down, investors often make biased decisions in order toavoid experiencing regret.
Professor Barbara Mellers at the University of California at Berkeleydesigned gambling experiments in which she found that the fear of regretleads to lower returns. After choosing a gamble and being hit with an un-expected loss, many subjects avoided subsequent higher-expected-valuegambles that were offered. Regret about a recent loss, even a loss as aresult of a random event (such as the ﬂip of a coin), drove people to irra-tionally reduce their risk taking.15
The fear of regret also affects how investors make initial buy and selldecisions. Researchers conducted surveys and experiments with a largegroup of individual investors and undergraduate students in the U.S. Mid-west. In the survey, investors were asked, “Thinking back to investment de-cisions you now regret, do you feel more regret for: (1) selling a ‘winning’stock too soon or (2) not selling a ‘losing’ stock soon enough?”16 Fifty-ninepercent reported more regret for not selling a loser soon enough, and 41percent for selling a winner too soon. Each side of the disposition equa-tion (winners and losers) was provoked. Regret was more aroused by notselling a losing stock soon enough.
The same experimenters asked subjects to participate in a game wherethey made their own investment decisions (buy, sell, or hold) over severalperiods of a simulated market. During the experiment, they were intermit-tently given the option of following the recommendation of a hypotheticalbroker they met at a party.17 After they purchased a stock, they watchedits price performance over a period, and then had the option of makinganother decision. As the experiment progressed, participants were askedtheir level of satisfaction with their prior decisions.
Interestingly, subjects reported more overall satisfaction simply fromowning a stock, regardless of the outcome. When the broker had givenaccurate advice, and the subjects had followed the good advice, they re-ported less overall satisfaction with the investment outcome than if theyhad made the buy decision independently. Making one’s own investmentdecisions is more emotionally gratifying than following a broker’s advice.However, if they lost money on a stock, they felt more regret if the initialdecision to buy had been theirs alone. Following a broker’s recommenda-tion reduced the emotional impact of losses. Brokers’ recommendationswere emotional shock absorbers, attenuating reactions to both proﬁts andlosses.
This ﬁnding may explain why most investors are willing to pay a pre-mium for actively managed funds and personal investment advisers. Theseprofessionals function as intermediaries between oneself and the out-comes of one’s investment decisions. Investors feel less emotional whendeferring some responsibility for ﬁnancial outcomes onto another.
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AN AMICABLE DIVORCE
Of every marriage performed this year in the United States, just over 40percent will end in divorce.18 Even when consensual, divorce has pro-found emotional effects on the couple. To comfort themselves during di-vorce, women often seek the solace of other friendships. Men generallyhave fewer intimate relationships than women, and they may be more so-cially and emotionally isolated during the transition into single life.
Doug came to my ofﬁce seeking help with his investing. He explainedthat he had been unsuccessfully trading volatile biotech and mining stocks.He had done such trading in the past with modest proﬁtability, but nowhe couldn’t handle the downside swings. He felt compelled to sell out ondeclines and frenetically chase fast-moving stocks higher during rallies. Hehad never traded so rapidly or poorly in the past, and he wondered whatwas happening. Overall, he was losing money quickly. In fact, by the timehe came to see me, Doug had lost 50 percent of his retirement savings.
During our ﬁrst interview, Doug casually mentioned that he was goingthrough a divorce that had been initiated two months previously. Accord-ing to Doug, the breakup was mutual and ﬁnal, and he didn’t think it wascausing his investing problems. Yet during out conversation, it became ap-parent that Doug was deeply attached to his ex-wife and her family. With-out her family and her circle of friends, he had few close relationships. Hehad no one to talk to about his emotional pain following the divorce. Nowhis deep hurt was impairing his judgment.
Without realizing it, Doug’s sadness and grief were increasing his risktaking. Fortunately, recent studies have shed light on the role of sadness inrisk taking. Psychologists think sadness creates the desire to change one’scircumstances. Sadness-driven stock transactions are fueled by hopes ofquick gains and offer a distraction from psychological pain.
SADNESS AND DISGUST
“The most common cause of low prices is pessi-mism—sometimes pervasive, sometimes speciﬁc toa company or industry. We want to do businessin such an environment, not because we like pes-simism but because we like the prices it produces.It’s optimism that is the enemy of the rationalbuyer.”
—Warren Buffett, 1990 Chairman’s Letter toShareholders
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All negative emotions, while of the same valence, do not affectdecision making similarly. Researchers have performed studies to teaseout the effects of speciﬁc negative emotions. Professor Jennifer Lernerat Carnegie-Mellon University induced states of sadness and disgust insubjects using short movie clips. She then studied how they priced theirbids and offers in a simulated marketplace. For example, she askedparticipants to ﬁll out a questionnaire in which they chose a price theywould accept in exchange for an item they had been given (such as a penhighlighter set). In another condition, subjects without the item indicatedhow much they would pay for it.
Lerner found that participants in a disgusted emotional state wereemotionally driven “to expel.” That is, disgusted people want to “get rid”of items they own, and they do not want to accumulate new ones. As a re-sult of the experimental subjects’ disgust, they reduced both their bid andoffer prices for the consumer items.
The “endowment effect” is a common cognitive bias in which peo-ple overvalue items they already own. The endowment effect causes theaverage seller to demand a higher price for an item than the averagebuyer thinks is reasonable. Inducing disgust led to the elimination of theendowment effect among both buyers (disgusted buyers lowered theiraverage bids) and sellers (disgusted sellers lowered the average offerprice).
In the case of sadness, Lerner noted that “sadness triggers the goalof changing one’s circumstances,increasing buying prices [bids] butreducing selling prices [asks].” When the researchers provoked sadnessin the subjects, the endowment effect was reversed.19 That is, comparedto people in neutral emotional states, people who had viewed sad movieclips subsequently valued items they owned less and items they did notpossess more. Recall that disgusted people valued all items less, whetherthey owned them or not.
Based on the inversion of the endowment effect, sad people shouldbe more likely to buy and sell items. Lerner speculated that this inversionis responsible for “shopping therapy” (in which people go shopping to lifttheir depressed spirits), and it may drive compulsive shopping, which is atype of psychiatric disorder. In fact, the best medication treatments forcompulsive shopping are antidepressants. Lerner notes that compulsiveshoppers tend to experience depression, that shopping tends to elevate thedepressed moods of compulsive shoppers, and that antidepressant medi-cation tends to reduce compulsive shopping.20
In the story of Doug, I speculated that the unacknowledged sadnessaround his divorce was driving excess transactions and risk taking in thestock market. In fact, Doug did well after he stopped trading and enteredpsychotherapy treatment. When he resumed investing nine months later,
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he was able to maintain a disciplined plan and he continues to trade suc-cessfully up to this writing.
FEAR AND ANGER
In another series of experiments, Professor Lerner examined the roles ofanger and fear in driving ﬁnancial risk taking. In advance of the experiment,she measured participants’ dispositional levels of fear, anger, and “opti-mism about the future” using standard surveys. Interestingly, she foundthat as levels of both anger and happiness increase in people, they report in-creasing optimism about the future. For angry people this optimism is pre-sumably because they feel in control. Fearful people report increasing pes-simism as their level of anxiety increases. Again, two emotions of negativevalence (fear and anger) have different effects on future expectations.21
According to Lerner, emotions characterized by a sense of certainty(such as happiness and anger) lead decision makers to rely on mentalshortcuts, while emotions characterized by uncertainty (such as anxietyand sadness) lead decision makers to scrutinize information carefully.22,23Anger and fear, while negative, differ in their dimensions of control, cer-tainty, and responsibility that accompany them. Angry people feel morecertain about the nature of an infraction, they feel that they have morecontrol over outcomes, and they feel that others are responsible for theprovocation. Fearful people are uncertain where the source of danger lies,lack a sense of control over stopping it, and are unclear who or what is re-sponsible for the threat.24 In order to identify the danger, they investigatetheir surroundings and new information more thoroughly.
Fearful people are averse to risk, while angry people are as comfort-able with risk as happy people. The decisive factor in risk taking is per-ception of control. Fearful investors feel insecure and out of control. As aresult, during market declines, the fearful are more likely to sell out. An-gry investors have identiﬁed the enemy and feel in control of the situation.They hold on to declining stocks because they are more certain of theirposition.
It is possible that the effects of fear and anger were seen in investorbehavior after the September 11, 2001, terrorist attacks in New York City.For the ﬁrst two weeks after the attacks, sad and fearful investors soldstock. Then, as no further threats materialized and the identities of theAl-Qaeda perpetrators became known, fear transformed into goal-directedanger, and the U.S. stock market rallied strongly for several months as theinitial war against the Taliban was prepared, initiated, and successfully ex-ecuted.
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Emotional individuals often have trouble predicting how they will feel inthe future. They incorrectly assume that their future emotional state willresemble their current one. As a result, they imagine that their currentpreferences will remain constant into the future. Because they cannotaccurately project themselves into the future and subsequently empathizewith their condition, they have a bias of “projection” when planning fortheir future selves.
For example, someone who receives a ﬁnancial windfall may havetrouble setting aside part of it in retirement savings. He is feeling that hewill always have enough money, and when the idea of retirement savings isbroached, he feels, “Why worry about squirreling money away when I’m soﬂush?” Studies have found the projection bias in people in emotional statesincluding anxiety,25 pain,26 and embarrassment.27
As a result of projection, most people underappreciate their powersof adaptation to unforeseen events.28 For example, if investors anticipatethat an international crisis might drive the U.S. dollar to all-time lows,they may extrapolate excessive damage to the American economy whileunderestimating the power of U.S. businesses to adapt.29,30 They may in-vest less in equities, even if they are earning lower expected returns inbonds.
Another error caused by projection is the exaggeration of the impactof attention-grabbing events.31 People generally assign a level of impor-tance to events that is proportional to the frequency they are mentioned.For example, investors are likely to overestimate the importance of widelypublicized world events (such as Middle East conﬂict) to their investmentportfolio. Meanwhile, they overlook other, much more profoundly world-changing events such as the emergence of China as an economic andpolitical power. Chapter 19 examines the nuances of this “attention effect”in detail.
One remedy for the projection bias lies in maintaining a healthy skepti-cism when attributing “moods” to the market. Another solution is to betterappreciate how one’s current and future emotional states alter one’s per-ceptions of ﬁnancial risk.
MANAGING FEELINGS
Most investors confuse emotion management with emotion control. Con-trol often refers to repression, which is dangerous. As noted in Table 6.1,when an emotion is not discharged, its pressures on judgment linger until it
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is worked through. Unfortunately, efforts to control emotional experiencemeet with little success, and they often have the unintended effect of in-creasing sympathetic nervous system activity32 (e.g., by raising blood pres-sure). High blood pressure can literally be a result of “bottling up” emotion.Researchers have found that encouraging subjects to attribute theirfeelings to situational factors and neutral facts reduces the impact of cur-rent emotional state on judgment. For example, reading a sad story lowersmost peoples’ estimates of life satisfaction. However, when people focuson the cause of their sad feelings before rating life satisfaction, this effectis reduced.33 People who understand why they are feeling sad (due to theirreading of the sad story) are more satisﬁed with life.
Unfortunately, if one’s emotional state matches his or her personal-ity style, then it may be more difﬁcult to manage. Neurotic people (withprominent anxious personality traits) will continue to rely on clues fromtheir anxiety to direct future decisions, even after they have identiﬁed theiranxiety as emanating from a neutral cause.34
When people ﬁrst become aware of the emotional inﬂuences on theirdecision making, they often have difﬁculty with over- or undercompensa-tion. Increased vigilance and self-awareness can be effective for reducingthe effect of weak to moderate emotions on decision making. It is help-ful if one sets up techniques for emotion management in advance for self-awareness interventions to be effective.35 When in a particular emotionalstate, one cannot clearly see how their thinking patterns have changed.
Since emotions alter one’s susceptibility to ﬁnancial decision biases,an ability to forecast future feelings could be used for personal beneﬁt. Forexample, the rare clients who tell their ﬁnancial planners, “Don’t let mesell if the market drops X percent,” are requesting that an external enforcerhelp them plan in advance for periods when their ﬁnancial anxiety is high.
SUMMARY
As seen in Chapter 5, low-level emotions underlie decision-making heuris-tics, such as the affect heuristic. Heuristics make possible a rapid, uncon-scious consolidation of complex information. The affect heuristic relies onsubtle emotional “tags” that indicate the relative “goodness” or “badness”of a decision option. The affect heuristic is a process by which complexinformation is simpliﬁed and given meaning. When information that hasbeen simpliﬁed using the affect heuristic is weighed and combined withother emotional cues, through a ﬁlter of experience, a “gut feeling” results.A “gut feeling” refers to the subtle, unconscious emotional judgmentthat forms in response to an uncertain decision situation. If one has
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experience with such situations, then gut feelings can be quite accuratejudgments. Optimal “gut feel” is the experienced interpretation of emo-tional cues.
Intuition relies on the rapid judgments that gut feel provides. Analytical
decision making can often be improved with intuitive input.
While gut feel can contribute to more accurate analytical decisions,moderate or strong emotions often lead to biased decision making.Fortunately for those who want to improve their decision-making process,emotion can be detected and managed with the right psychological tools,primarily through the internal honing of emotional intelligence skills.
A lot of technical information about moderate to strong emotions wascommunicated in this chapter, and I’ll quickly summarize the effects of spe-ciﬁc emotions here. Regret, such as Jodie was feeling in the introductorystory, prompts conservatism with existing assets and increased risk tak-ing with money-losing ones (holding onto losers). Anger gives rise to mildoptimism, a sense of control, and certainty about one’s ﬁnancial choices.Overall, angry investors have less stock turnover. Sadness (perhaps unusu-ally) leads to increased investment risk taking and increased trading. Whenafraid, investors usually overestimate danger and are more likely to believethreat-related information. When happy, they underestimate risks and trustpositive prognostications from similarly optimistic experts.
Chapters 7 through 10 detail the emotional states that most impair objec-tive investing: fear, stress, greed, and hubris.
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C H A P T E R 7
Excitementand GreedHooked on a Feeling
“If investing is entertaining, if you’re having fun,you’re probably not making any money. Good in-vesting is boring.”
—George Soros
Jonathan Lebed was 14 years old the ﬁrst time he was subpoenaed
by the Securities and Exchange Commission (SEC). Then at the ageof 15, Lebed was again subpoenaed, this time for “pump-and-dump”schemes. Such schemes entail buying the shares of illiquid or infrequentlytraded stocks, advertising the beneﬁts of the stock widely, and then sellingone’s shares as other eager buyers snap them up at a higher price. In a pressrelease, the SEC accused Lebed of touting stocks so that he could make aquick proﬁt on their price jumps:
On eleven separate occasions between August 23, 1999 (when Lebedwas 14 years old) and February 4, 2000, Lebed, of Cedar Grove, NewJersey, engaged in a scheme on the Internet in which he purchased,through brokerage accounts, a large block of a thinly-traded microcapstock. Within hours of making the purchase, Lebed sent numerousfalse and/or misleading unsolicited e-mail messages, or “spam,” pri-marily to various Yahoo! Finance message boards, touting the stockhe had just purchased. Lebed then sold all of these shares, usuallywithin 24 hours, proﬁting from the increase in price his messageshad caused.1
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The SEC explained that Lebed was criminally liable because the stockforecasts that he posted on web sites and through e-mail “included baselessprice predictions and other false and/or misleading statements.”
Yet Lebed was a marketing genius. According to Michael Lewis, au-thor of the best-selling books Liar’s Poker and Moneyball, Lebed learned togradually hone the appeal of his promotional messages. It should have beenapparent to investors buying his recommendations that they were on thewrong side of the trade. Through a trial-and-error process, Lebed learnedwhich aspects of his stock appeals drove investors to buy in spite of anyconscious misgivings.
According to Michael Lewis, two days before the SEC’s subpoenas ar-rived, Lebed had logged on to the Internet and posted 200 separate timesthe following plug for a company called Firetector (ticker symbol FTEC):
Subj: THE MOST UNDERVALUED STOCK EVER
Date: 2/03/00 3:43 PM Paciﬁc Standard Time
From: LebedTG1
FTEC is starting to break out! Next week, this thingwill EXPLODE. . . .Currently FTEC is trading for just $2 1/2! I am ex-pecting to see FTEC at $20 VERY SOON.Let me explain why. . . .
Revenues for the year should very conservatively bearound $20 million. The average company in theindustry trades with a price/sales ratio of 3.45.With 1.57 million shares outstanding, this willvalue FTEC at . . . $44.It is very possible that FTEC will see $44, but sinceI would like to remain very conservative . . . myshort-term target price on FTEC is still $20!The FTEC ofﬁces are extremely busy. . . . I am hear-ing that a number of HUGE deals are being workedon. Once we get some news from FTEC and theword gets out about the company . . . it will take offto MUCH HIGHER LEVELS!
I see little risk when purchasing FTEC at theseDIRT-CHEAP PRICES. FTEC is making TREMEN-DOUS PROFITS and is trading UNDER BOOKVALUE!!!2
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Lebed found that he could hide his identity on the Internet. He couldsend compelling messages, with a veneer of expertise, while none of thereaders knew the author was only 15 years old.
Arthur Levitt, chairman of the SEC during the Lebed indictment, de-scribed Lebed’s scheme in a pithy remark on a 60 Minutes special: “Apump-and-dump is really buy, lie, and sell high.”3
The SEC’s case against Lebed was settled out of court. Lebed repaid$285,000 (including interest) to the SEC on behalf of investors who hadbeen duped by his pump-and-dump schemes. The settlement allowedLebed to keep more than $500,000 earned during his stock promotionactivities.
As of 2006, at age 22, Lebed continued to do small company researchpromotions through both his web site (www.lebed.biz) and promotionale-mails.
The SEC indicted Lebed because they claimed he was seeking to ma-nipulate the market. Yet pump-and-dump hyping happens with some fre-quency. Why do people fall for this scam over and over when it directlyand unmistakably leads to ﬁnancial loss?
Stacie Zoe Berg, writing in TheStreet.com, identiﬁes the lure of thepump-and-dump as playing into investors’ “belief that it’s easy to ﬁndwinners.” Berg suggests that pump-and-dump scams primarily recruitnaive investors: “Others fall for scams because they were late entering themarket and want to catch up with the winnings it seems everyone else isreaping. This greed and desperation make investors putty in the hands ofthose willing to take advantage of them.”4 Yet the question remains: whatpredisposes investors to “greed and desperation,” and how is a speculativefrenzy ignited?
This chapter examines the origins and the anatomy of investors’ excite-ment, hope, and greed. Recent studies into the ﬁnancially destructive con-sequences of excessive excitement during decision making are discussed.Finally, it delves into the anatomy of the promotional language that excitesinvestors.
BROKERS KINDLEIRRATIONAL EXUBERANCE
It wasn’t only Lebed who was preying on excited and gullible investors dur-ing the Internet bubble. In the late 1990s online brokerage advertisementsreﬁned their appeal for day traders’ unconscious triggers. Televisioncommercials for online stockbrokers emphasized both the ease andproﬁtability of such trading and were rich in positive emotional imagery.
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Professor Brad Barber at
the University of California at Davisperformed a content analysis of 500 television commercials from 13brokerages. He found that 28 percent of all commercials between 1990and 2000 depicted images and messages likely to induce good or positivemoods in viewers, and the percentage of such commercials more than dou-bled from 12.39 percent in 1990–1995 to 32.98 percent in 1996–2000. Barberspeculates that because people in moderately positive moods tend to beless thorough and less vigilant decision makers, are more subject to cogni-tive biases, and rely more on heuristics (than people in moderately negativemoods), the brokers were trying to induce such moods in their viewers.5
One Discover Brokerage Direct television commercial depicted a con-versation between a passenger and a stock-trading tow-truck driver whoowned an island-nation all his own.6 Other television commercials in-cluded a stock-trading teenager who owned his own helicopter.7 A series ofSchwab commercials