he had never owned any other stocks—his only equity holding was IP,and it contributed over 70 percent of the value of all of Sharon and Tom’sassets.
Sharon and Tom had never discussed buying stocks or bonds. She hadno interest in investing. She approached Jim in order to get her ﬁnances inorder before retirement.
Over their ﬁrst few meetings, Jim discussed the concept of ﬁnancialrisk diversiﬁcation and its foundation in mathematical principles. He ex-plained that Sharon could greatly reduce her ﬁnancial risk and probablymake better returns over time if she was willing to sell some of the IPstock. He offered a number of suggestions including the addition of bondsand mutual funds to her portfolio, and this would require paring back thenumber of IP shares held.
Sharon politely declined his offers to sell some of the IP stock. Afterseveral meetings, and feeling that he wasn’t properly communicating thefacts of her ﬁnancial risk to her, Jim more insistently pushed the idea ofdiversiﬁcation. He felt that it was his job to protect her from unexpectedmarket risk, and she wasn’t letting him do his job if she so stubbornly
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resisted selling some IP shares. Jim pushed Sharon to let him diversify herportfolio more aggressively at each meeting.
Six months after they had entered an adviser-client relationship,
Sharon told Jim, “Please stop.”
Jim responded, “I don’t understand.”“Stop telling me to diversify.”“Okay, I’ll stop if you’ll just explain why.”Sharon replied impatiently, “Look, I’ve been telling you for months, I
can’t sell that stock.”“Why not?’“Because it’s Tom’s!”“Tom’s stock!?!?”Sharon didn’t respond. She looked away, and Jim saw that she wasupset. He realized he had said something wrong, but he still didn’t quiteunderstand the problem. Sharon was attached to IP because she associatedit with her husband.
Investors often become emotionally attached to stocks for differentreasons, such as special memories or a feeling of gratitude for its previousﬁnancial rewards.
In general, women are more susceptible to attachment and biases ofemotion and memory than men, and these biases affect how women dealwith stocks. In the following section, I outline some of the research thatdemonstrates men and women’s different propensities for emotion-basedinvesting. Later in the chapter, the discussion turns to the effects of agingon investment decision making and notable differences between Easternand Western stock investors.
EMOTIONAL MEMORIES
Though it may sound stereotypical, in numerous psychology and neu-roimaging studies, women demonstrate better memories of emotionalevents then men. In one experiment, subjects either viewed negativelyarousing pictures (such as pictures of surgical operations) or neutralpictures (such as a door). Three weeks after the experiment, negativelyemotional pictures were remembered better by the female participantsthan the male. During recall, women had brain activations characterizedby negative emotional experience (the left amygdala), while men useda more fact-based memory structure (the right amygdala). In general,women appear to have enhanced memory (over men) when emotion isassociated with an event.1
Some interesting hypotheses can be drawn for investors. Womenwho have lost money in the markets are more likely to retain negative
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memories of investing, and as a result, they are more likely to keep theirmoney on the sidelines after a bear market. Men are more resilient follow-ing negative emotional experiences, and are thus more likely to “get backon the bull” even after a painful correction. This can be unfortunate for menwho don’t know what they’re doing—difﬁculty learning from painful invest-ing mistakes is probably a key contributor to overtrading among men.
Since people differ in their levels of “masculinity” and “femininity,”some researchers asked subjects their masculinity/femininity ratings andthen tested their memory function. People who rated themselves highlyon femininity had strong emotional memory formation, while self ratedmasculine respondents exhibited enhanced factual recall.2 In general, men(and masculine women) process investment information more accordingto its factual basis (such as the raw numbers), while women (and femininemen) may be more attuned to emotional aspects of an investment (such asits degree of social responsibility).
THE FEMALE BRAIN: ESTROGEN, EMOTION,AND COOPERATION
Women’s superior emotional memories are enhanced by the effects of thehormones estrogen and progesterone. These hormones alter emotional ex-perience and behavior, most notably when estrogen is low just prior tomenstruation, which is associated with the irritability of premenstrual syn-drome. During pregnancy, estrogen remains at relatively high levels, andmany women report feeling especially joyful during the second and thirdtrimesters of pregnancy due to the saturation of their brain’s estrogenreceptors.
Studies of rats in estrus (low estrogen) ﬁnd that these rats have apoorer ability to withstand cognitive stress. Researchers hypothesize thatthis cognitive stress reactivity is related to supportive effects of estrogenon the prefrontal cortex, and this support is withdrawn when estrogen lev-els are low.3,4 It seems to follow that female investors, especially thosewith signiﬁcant premenstrual dysphoria (bad mood before menstruation),may be better off avoiding stress-inducing investment decisions when theirestrogen is low. Low estrogen women are more sensitive to potential risks,and their reactivity to negative events is likely to be enhanced.
One tool that economists use to measure people’s tendency to co-operate versus cheat is a game called the prisoner’s dilemma (describedin the glossary). Using functional magnetic resonance imaging (fMRI),researchers have found that during a prisoner’s dilemma game, womenshowed greater reward system activation on fMRI when engaging in
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cooperative behavior than in deceptive behavior.5 Other studies haveshown that men are more likely to experience reward system activationwhen taking revenge.6 These ﬁndings may underlie the tendency forwomen to value cooperation over conﬂict, even when deceived, while menare more openly aggressive when believing that another has cheated them.I often receive questions from participants in investment committeesabout how roles and relationships can be facilitated. There are interestingimplications of gender research to such groups. In investment committees,men may be more driven to settle political scores or engage in one-upmanship than cooperate in choosing optimal stock investments. Con-versely, men’s aggressive drives may lead them to stand against an erro-neous crowd decision, while some women may be more likely to agree withthe group majority in order to preserve social harmony. Men are less likelyto communicate about conﬂict before they act, while women tend to uselanguage to understand and defuse interpersonal crises. However, it shouldbe noted that one’s degree of of masculinity or femininity is probably moreinﬂuential over investment committee behavior than one’s gender.
FINANCIAL PLANNING FOR DIVORCEES
Mark is a ﬁnancial planner who shared with me a story of gender-relatedmisunderstanding. Mark had left his job at a nationally known investmentadvisory to start his own ﬁrm, and he asked his existing clients to followhim into his private practice.
Mark said that among his advisory clients, it was the middle-aged fe-male divorcees who were reluctant to follow him to his new ﬁrm. He hadexplained the ﬁnancial and personal beneﬁts of the new arrangement withthem, and he had encouraged them to think about the costs and bene-ﬁts of the transition before making a decision. “Couldn’t they understandthe beneﬁts—lower fees and personalized services?” he asked me. Markhad repeatedly discussed the “facts”—data about potential fee savings andhigher returns—with his reluctant clients. He was mystiﬁed that they werestill uncertain.
Mark was trapped in an empathy gap. He did not understand how hisclients were feeling, so he could not address their needs. Women are lessconvinced of an investment’s beneﬁts by numerical analyses (factual in-formation) than by their trust and conﬁdence in the planner (emotionalrapport). Furthermore, for Mark’s divorced clients, watching him leave hisestablished ﬁrm to strike out on his own may have provoked a vaguely fa-miliar and painful memory of when their own long-term relationship ended.Additionally, Mark may not have understood that women are more riskaverse than men, and a transition to a new ofﬁce felt like more risk thanthey were willing to take.
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I discussed these issues with Mark, and he seemed a bit bafﬂed. He hadtrouble believing that some women would be driven by subtle feelings andmemories instead of the data. For Mark, his clients’ feelings seemed irrel-evant, and potentially threatening. If he acknowledged their importance,he might realize that an enormous domain of human experience had previ-ously been hidden to him.
MALE OVERCONFIDENCE
While women are more often risk averse, men (especially young men) areoverconﬁdent in their ability to handle risk. Professors Odean and Barberanalyzed the trading records of 35,000 households from a large discountbrokerage ﬁrm from February 1991 through January 1997. “Consistent withthe predictions of the overconﬁdence models, we document that men trade45 percent more than women and earn annual risk-adjusted net returns thatare 1.4 percent less than those earned by women.”7 Being single increasesthe risk of overconﬁdent trading: “These differences are more pronouncedbetween single men and single women; single men trade 67 percent morethan single women and earn annual risk-adjusted net returns that are2.3 percent less than those earned by single women.”8
In general, young men are more risk seeking in their investments, trad-ing stocks more and taking greater overall ﬁnancial risks than youngerwomen.9 Biologically, such risk taking may result from the fact that youngmen have a relatively desensitized reward system dopamine circuit com-pared to later in life—just like pathological gamblers and people inducedinto a sad state, they seek risk taking and novelty to stimulate theirdopamine tone. It’s not only dopamine that drives male risk-taking. Theirbodies are hormonally primed to take risks during their youth.10
Evolutionary biologists hypothesize that young single men are drivento try to capture more social and ﬁnancial gains while young, thus takingmore risk in pursuit of their goals. When older, men spend more time con-solidating and leveraging their existing assets than seeking high-risk newopportunities.
AGE
There is a plethora of data emerging about the ways in which our brainschange with age. Those changes can be either helpful or hurtful to one’sﬁnances. Most people age gracefully, working around age-induced limita-tions and focusing more adroitly on their strengths. Older adults are alsofavored by two healthy personality trends.
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As people age, they tend to become both less neurotic and more con-scientious. In Chapter 12, neurotic investors reported making more invest-ment mistakes than emotionally stable investors. On average, older adultsreport strikingly decreased levels of neuroticism (increased emotional sta-bility) as compared to the young. Further, older adults tend to be moreconscientious (more self-disciplined and organized) than younger adults.
A brain imaging study showed that the process by which older adultsbecome more emotionally stable is credited not to a loss of limbic systemvitality, but to increased strength in the prefrontal cortex, which inhibitsunruly limbic impulses.11 Emotional stability improves linearly over sevendecades of the human life span. Technically speaking, improved emotionalstability and impulse control (conscientiousness) is due to a shift towardgreater medial prefrontal control over negative emotional input.12
Younger people have greater nucleus accumbens activation than olderadults on fMRI studies of ﬁnancial reward anticipation.13 Older investorsare more likely to take their time researching and forming strategy beforebuying into a stock. And older adults take fewer ﬁnancial risks overall,especially after retirement.14
In general, as people age from childhood to adulthood, they processless information more qualitatively. The same information processing pat-tern is seen as people increase in their level of expertise.15 Mental short-cuts provide for increased cognitive efﬁciency and thus faster processingof decision situations that have previously been experienced.
As older adults reach their seventies, the strength of the connectionbetween their prefrontal cortex and the limbic system weakens. If the con-nection is signiﬁcantly impaired, and their prefrontal cortex cannot inhibitexcited impulses or integrate risk-related information, then they may bemore easily coerced into fraudulent investment “opportunities.”
In general, older people are more risk averse than younger partici-pants during experimental gambles. Older adults (over 70) are more easilyconfused by complex ﬁnancial decisions. Because of this easy confusion,which may be a result of cognitive slowing, they often avoid dealing withinvestments, instead deferring decisions to younger family members or en-tirely refusing to make decisions. Younger people are more likely to makeﬁnancial mistakes due to excessive risk taking.16
THE SEATTLE LONGITUDINAL STUDYOF ADULT DEVELOPMENT
Since 1903, psychologists, schoolteachers, and other researchers havetests to cohorts ofbeen administering standardized psychological
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TABLE 20.1 Cognitive Skills and the Age of Initial Decline
Skill
Deﬁnition
Verbal Ability
The ability to understand ideas
(Comprehension)
expressed in words.
Spatial Orientation
The ability to visualize and mentallymanipulate spatial conﬁgurationsin two or three dimensions, tomaintain orientation with respectto spatial objects, and to perceiverelationships among objects inspace.
Age at Which GradualDecline Begins
81, but today’s youthhave decreased skillcompared with priorgenerations
67
Inductive Reasoning The ability to recognize and
67
understand novel concepts orrelationships; it involves thesolution of logical problems—toforesee and plan.
Numeric Ability
The ability to understand numerical
relationships, to work with ﬁgures,and to solve simple quantitativeproblems rapidly and accurately.
60, but today’s youthhave decreased skillcompared with priorgenerations
Perceptual Speed
The ability to ﬁnd ﬁgures, make
60
comparisons, and carry out othersimple tasks involving visualperception with speed andaccuracy.
Verbal Memory
The ability that involves
67
memorization and recall ofmeaningful language unitsprimarily measured by memorizinglists.
thousands of individuals in Seattle, Washington. The goal of the researchis to keep track of cognitive performance of individuals as they age.The researchers give a battery of tests to their subjects, and they retesteach individual every seven years over their life span. The tests assessverbal skills, spatial skills, reasoning ability, numeric ability, and othercharacteristics of cognitive functioning. See Table 20.1 for a complete listand deﬁnitions of skills assessed.17
The researchers looked at how individual scores changed overtime—over the lifespan. Do people lose certain abilities, gain some skills,
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or a mix of the two? Next, the authors examined how individuals born inone decade compared to individuals of the same age studied in subsequentdecades. Do people born 50 years ago have the same talents and skills asmodern adults?
When groups from 1903 and every seven years thereafter are followedover time, the earliest observed cognitive decline occurs for perceptualspeed and numeric facility beginning at age 60. Inductive reasoning, spatialorientation, and verbal memory begin to decline by age 67. Verbal abilityremains robust until age 81.18 In general, the declines are relatively minoruntil age 80, when they all begin a more precipitous drop.
In an alternative analysis of the data, different generations are com-pared to each other when they are at similar ages. For example, thecognitive skills of 20-year-olds in 1903 could be compared to those of20-year-olds in 2005. When such a comparison is made, there is generallya superiority of skills evident in the more recent generations, except inthe areas of verbal and numeric ability, which are inferior to those of theirgrandparents’ generation.
It’s also known that genetic factors contribute to decreasing cognitiveabilities over the lifespan. In particular, the apolipoprotein E (ApoE) geneis a risk factor for Alzheimer’s disease, a form of dementia. In the Seattlestudy, a signiﬁcantly greater rate of cognitive decline over the seven-yearintervals was noted in individuals with one or two copies of the ApoE gene(e4/2 and e4/4 allele pairings).19
There are small decrements in declarative memory that accompanynormal aging. These may be represented by an inability to recall people orevents that have recently occurred. These decrements are related to smallage-related impairments in the function of the hippocampus, a brain re-gion that encodes recently experienced events, conversations, and dailyinteractions. People with the ApoE4 allele have more pronounced deﬁcitsin the hippocampus due to a build-up of proteins (transcribed by the gene)that interferes with neural transmission during aging. Fortunately, one’smemory for facts and ﬁgures remains relatively intact until later in normalaging.
Another prominent change in the brain with aging is thinning of theprefrontal cortex. A decreasing ability to multi-task, perform mental calcu-lations, and rapidly shift attention are caused by this thinning.
The preceding changes may explain, in part, the tendency for olderpeople to be vulnerable to ﬁnancial fraud. If their numeric ability falterswhile their verbal ability remains intact, they may not understand the fun-damental risks of an investment prospect yet show no outward signs ofincompetence. Up to one-half of all elder abuse cases in the United Statesinvolve ﬁnancial fraud, accounting for over 500,000 victims.20 Also, due totheir slower processing speed, they may simply accept a ﬁnancial adviser’s
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“word for it” rather than taking the time and effort to do their own duediligence.
What causes these age-related deﬁcits? Given the strong results from askill-training protocol, it appears that much of the decline can be attributedto a lack of use: “Use it or lose it.” Increasing prefrontal usage may im-prove the ability to learn and plan, thus minimizing age-related cognitivelosses.21
In the 1970s, the Seattle researchers began a training program, to seeif they could sustainably improve the skills of the test subjects and fore-stall or prevent decline. They found that when a simple training programis administered to older individuals in order to delay or reverse the declinein skills, the trained subjects show a sustained improvement in their skillsover time. Those who do not receive the training have a precipitous dropin their abilities.22
The bad news about brain aging is that the prefrontal cortex and thehippocampus (factual memory center) do lose some of their strength. Thegood news is that there are now books and software products that promotespeciﬁc exercises to strengthen these areas of the brain in the aged. A SanFrancsico company, Posit Science, sells software products that it reportscan train the brain to lose the cognitive equivalent of one decade of aging.But before you run out and buy software or puzzle books for your agingbrain, a simpler answer is close at hand—novelty. Engaging in unique chal-lenges and new activities can strengthen the brain just as well as speciﬁcexercises. The brain is like a muscle, and you can either exercise speciﬁcareas using software or books, or you can challenge the whole thing toexplore and solve on a larger scale (or do both).
There are some beneﬁts to aging as well. Older adults are moreemotionally stable, conscientious, and able to recognize patterns inrelationships and life events. They can make more rapid routine decisionsbecause they have entrenched “heuristics” (short-cuts) for thinking aboutfamiliar circumstances. Older adults also maintain their accumulatedexpert knowledge well. As long as adults remain curious and interestedin the world and their workplace, and they are physically healthy, theyshould be able to maintain employment at least until the mid-80s. It may bethe case that too many are retiring early because they think they should,not because they have lost any particular expertise.
CULTURE (EAST AND WEST)
The ﬁrst time I visited China, in 1992, communism was still very much inevidence and the Shanghai and Shenzhen stock exchanges had been in
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existence for less than two years. State-run department stores were thesource of most retail goods. State employees seemed laconic, condescend-ing, and occasionally hostile. The stock exchanges were new and small,with most shares only nominally traded.
When I again visited China in 2001 and 2004, China and its capital mar-kets had undergone a revolution. Elaborate stock brokerage houses weresituated on large thoroughfares throughout major cities. Day traders andretirees ﬂocked to trading houses, where they sat in customized tradingstations and intently watched computer monitors and the “big boards” inthe stadium-sized brokerage foyers.
When a country of 1.3 billion people undergoes an economic renais-sance over only twenty years, there are bound to be extraordinary periodsof investor and stock market behavior. Unfortunately, there is a very lim-ited amount of cultural comparative literature relevant to ﬁnance. Most ofthe research into cultural investment attitudes compares Western (Ameri-can or European) to Eastern (Chinese, Japanese, or Taiwanese) investors.There has been little research done on South Asian, Middle-Eastern, LatinAmerican, or African investors.
While you saw earlier in this chapter that there are signiﬁcant biologi-cal differences between male and female and older and younger investors,there are few signiﬁcant cultural differences in investment behavior be-tween Easterners and Westerners that cannot be explained by differinglevels of economic development or ﬁnancial education. Yet cross-culturalinvestment research does yield some interesting ﬁndings.
CHINESE RISK TAKERS
Many studies of ﬁnancial risk taking and perception ﬁnd that Easternersare more risk tolerant than Westerners. Professor Elke Weber found sucha result when comparing risk attitudes and behavior of Chinese to Amer-ican investors. Dr. Weber attributes Chinese risk taking to larger socialstructures, which insulate members against catastrophic losses.23 Otherresearchers speculate that a lack of knowledge about the relationship be-tween risk and return among the current generation of Chinese investorsmay alter risk taking attitudes,24 and there is one study with evidence tothat effect among horse bettors.25
When examining the process of decision making, as inferred fromChinese and American novels, Professor Weber found that Chinesedecision-making patterns are more focused on relational considerationsand role-based logic. Analytic modes of processing, in which decisions arebased on a cost-beneﬁt consideration of best outcomes, was more typical
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of American novels.26 Perhaps worryingly, Chinese corporate boards maybe more deferential to leaders’ opinions and less inﬂuenced by cost-beneﬁtanalyses.
The above ﬁndings indicate that while Chinese take more ﬁnancialrisk, they are less attuned to probabilistic outcomes and are more awareof the social networks that provide support for risk taking (in case offailure). Because Chinese investors have a form of extended social (family)insurance, they can be less concerned with the probability of large losses.As a result, they will engage in more rational risk-taking behavior thanrisk-averse Americans.
BIASES AMONG CHINESE STOCK TRADERS
Individual Chinese investors demonstrate similar behavioral biases toWestern investors. Chinese and American researchers examined the trad-ing records of 46,969 individual investor accounts from ﬁve cities in thePeople’s Republic of China from May 20, 1998, to September 30, 2002. Theauthors found evidence for overconﬁdence (overtrading and buying basedon too little information), the disposition effect (holding losers too longand cutting winners short), and representativeness (chasing) among Chi-nese investors. Even experienced Chinese investors showed signiﬁcant ev-idence of such behavioral biases.27
Chinese investors held past losers too long and sold past winners toosoon. After one year, the stocks they sold outperformed the stocks theybought by 2.5 percent. This was a return that is negative, but slightly better,than that found by Odean in his study of over 60,000 American brokerageaccounts.
Chinese investors also “chased” past winners. The average returns ofstocks four months before their purchase was over 17 percent (a 32 percentexcess return). The past one-year return of these stocks was 2.9 percent,implying that investors focus on the most recent short-term performanceof the stocks purchased. In this case, Chinese investors are focused on theshort term, chasing fast moving stocks upwards, even more than investorsin other regions.
Because of their insufﬁcient diversiﬁcation and frequent trading, theauthors labeled the studied Chinese investors as “overconﬁdent.” However,it should be noted that more frequent trading actually led to higher returns(on the order of 0.5 percent per month) during the study period than forless frequent traders.28
More evidence of the disposition effect was gathered in a surveyof investors by the Shenzhen Stock Exchange in 2002—54.1 percent of
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individual investors reported that they would sell their stocks if prices roseby 10 percent. When asked what they would do if they suffered a loss, only27 percent of the investors reported that they would close their positions.In Taiwan, market makers on the TAIEX index options exchange werefound to take above-average risks in afternoon trading after morning gains.In fact, the proportion of market makers with morning gains inﬂuencesliquidity and volatility in afternoon trading.29 This evidence of the housemoney effect is stronger for the TAIEX traders than among professionaltraders in Chicago, where researchers also found that more successfultraders took greater afternoon risk after morning gains. With experience,however, the extent of increased afternoon risk taking after morning winsappears to decrease.30
Using past price patterns as a proxy, evidence for herding has beenfound in Chinese equities—more strongly in the more illiquid B-sharemarkets.31 Among Chinese investors, trading can be a virtual team sport.Researchers found that investors who work near each other are more likelyto buy the same stocks (usually locally headquarted), probably due to“word-of-mouth” effects. These investors are also more likely to sell stockin the same companies (typically nonlocal).32 The same type of cluster-ing has even been found among American mutual fund portfolio managerswho work at different funds but live in the same city. Such idea-contagionis true internationally, but exaggerated in China due to the “team-sport”conﬁguration of stock trading houses.
In summary, women and men have different trading patterns. Womenbetter retain emotional memories and are more risk averse, while men takeexcessive ﬁnancial risks and have lower long-term returns. Investment risktaking varies over the life cycle, which may be a result of changes in cogni-tion as age progresses and risks are more difﬁcult to understand. Chinesestock traders take more risk than their Western counterparts, but also aresusceptible to many of the same behavioral biases, such as overconﬁdenceand the disposition effect. Representativeness (chasing) is more commonamong Chinese risk takers.
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In Practice
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C H A P T E R 21
EmotionManagementA Balancing Act
“Always acknowledge a fault. This will throw thosein authority off their guard and give you an oppor-tunity to commit more.”
—Mark Twain
G eorge Soros, Warren Buffett, Paul Tudor Jones—these men seem
like investing naturals. Do they have an innate talent? Undoubtedly.What psychological characteristics make them great? Certain traits,such as adaptability, conﬁdence, optimism, and emotional stability, lead tooutstanding performance