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Money transfers are also affected by “trust signals,” namely how muchmoney one player sends to the other over each round.
In a study using the ultimatum game, some fascinating disparitiesamong age groups and genders were noticed. In the experiment, peopletended to preferentially trust others in their own age group. Young partici-pants were signiﬁcantly more trusting than older subjects, sending 24 per-cent more money to their partners than did older players. There was alsoa very strong gender effect in this study, where women were both moretrusting of others and perceived to be more trustworthy than men.33
In a variation of the trust game called the “ultimatum game,” proposersoffer to split a sum of money with the responders. If the responders rejectthe proposal, then neither party receives money. In a fMRI study, respon-ders with high activation in the insula when they contemplated unfair of-fers were more likely to reject them.34 By refusing the unfair offer, respon-ders were acting based on their emotions (disgust and pain) and forgoingguaranteed proﬁts. In the markets, such a rejection of “unfair”events canbe damaging. For example, after a company’s negative earnings surprise,investors should suppress the urge to punish it (by selling stock) if theirresearch shows that it continues to be fundamentally undervalued.
British fMRI researchers asked subjects to rate pictures of faces interms of their “trustworthiness.” Activity in the bilateral amygdala and rightinsula increased when faces judged to be untrustworthy were presented.An area of the temporal lobe was activated when trustworthy faces wereviewed. The researchers noted that the temporal cortex activation implieda cognitive intention to trust, while mistrust was an automatic negativeemotional reaction.35
If untrustworthy individuals have an “honest face,” then they can avoidprovoking immediately negative emotional assessments. Of course, inten-tional facial manipulation, such as former Enron CEO Ken Lay’s generoussmiles, can disarm the automatic negative amygdala and insula reactionsthat would have promoted avoidance. Additionally, now there is some indi-rect evidence that it is important for ﬁnancial advisers to be both physicallypresentable and ﬁnancially generous (e.g., fee discounts) with clients in or-der to encourage trust and prevent emotional misunderstandings.
THE TRUST HORMONE
Paul Zak, a professor at Claremont Graduate University in southernCalifornia, has taken a keen interest in the cultural role of trust in eco-nomic activity. Zak has run several studies examining the role of a hormonecalled oxytocin in facilitating trust. Zak ﬁrst became interested in oxytocin
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when he read a Science magazine article describing the role of oxytocin involes.
Voles are a genus of rodent living in North America. Prairie voles liveon the Great Plains, while the mountain vole inhabits the Rocky Mountains.These two species are identical in all respects except sexual behavior. Themountain vole is very promiscuous, while the prairie vole selects one matefor life. When researchers examined the voles’ hormone levels, they foundthat the prairie vole has very high oxytocin levels relative to its promiscu-ous mountain cousin.36
Oxytocin in humans facilitates bonding between mother and baby.Breast-feeding releases oxytocin in both the mother and infant. Addition-ally, orgasm increases a woman’s oxytocin levels, perhaps allowing her tobond with her mate. Zak wondered whether oxytocin might affect trustingbehavior during a “trust game” (the ultimatum game), so he set up a studyto ﬁnd out.
Zak found that responders who were given higher levels of money bythe proposer had increased oxytocin following the transfer.37 Additionally,responders who returned more money to the proposer were found to havehigher levels of oxytocin prior to reciprocating. Zak believes it was theresponders’ perception of trusting behavior from the Proposer that raisedtheir oxytocin levels. Simply receiving money without implied trust did notraise oxytocin levels.38
Zak, in collaboration with Swiss researchers, found that proposersgiven an oxytocin medication (via intranasal squirts) were more likely totransfer a larger amount of money to responders39 at the beginning of theexperiment. In fact, approximately 45 percent of the proposers given oxy-tocin transferred the entire initial sum, versus 20 percent of those givenplacebo.
Zak may have uncovered a biological mechanism (oxytocin level) forsuch investor biases as the endowment effect (loving a stock), the urgeto reciprocate ﬁnancial adviser fee discounts, confusion between loving acompany and seeing its stock as a good investment, and the home bias.
IMPLICATIONS
Investors should calculate the expected value of every investment optionbefore selecting the optimal choice. However, judgments of expected valueare biased by risk perception. The fear of “riots” before the 2000 Mexicanpresidential election raised risk perceptions and sent the markets tumbling20 percent.
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Because the future is intrinsically uncertain and market dynamicschange, the past is a poor guide to the future. When assessing ambiguousor uncertain information, investors overestimate the probability of danger.They often utilize the emotional defense mechanism of projection, whichdrives them to overestimate risk in ambiguous data due to their own fear.Emotions such as fear also lead to the overestimation of the likeli-hood of low probability events that are vivid or emotionally weighted. Egoattachment to particular outcomes increases the severity of such biases.Self-awareness of risk-perception biases is challenging due to the thoughtdistortions that arise from unconscious emotions. One will truly think thatthe danger exists and will search for conﬁrming evidence to justify theirfearful risk aversion.
Trust appears to be strongly related to perceptions of risk, and in-vestors perceive less risk in situations where they trust both the infor-mation they receive and the source delivering it. In the case of unfamil-iar stocks or markets, investors will usually be less trusting and will thushave greater risk perceptions. This may explain why most developed-worldinvestors prefer local or national, rather than international, investments,even when greater returns are available overseas.
The hormone oxytocin promotes trust. Its levels rise when peopleare shown generosity, and it correlates with increased attachment, invest-ment, and reciprocal behavior. On a broad national and cultural level, trustappears to correlate with market returns. Professor Paul Zak found thatOECD countries with higher trust levels had higher stock market returnsduring his sample period (1990–2000).
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C H A P T E R 14
FramingYour OptionsSeeing the World in Blackand White
“Selling companies that are doing well and pur-chasing ones that are faring poorly is like wateringthe weeds and cutting the ﬂowers.”
—Peter Lynch, Fidelity Positions
JR. Simplot is an American eighth-grade dropout and a self-made multi-
billionaire. He made his fortune through saavy investments in potatofarming and french fry production. Currently, he owns the largestranch in the United States, the ZX Ranch in southern Oregon. His ranch islarger than the state of Delaware. Despite his tremendous wealth, Simplotis a modest man. He describes his accumulation of wealth to Eric Schlosserin Fast Food Nation:
“Hell, fellow, I’m just an old farmer got some luck,” Simplot said,when I asked about the keys to his success. “The only thing I didsmart, and just remember this—ninety-nine percent of people wouldhave sold out when they got their ﬁrst twenty-ﬁve or thirty million. Ididn’t sell out. I just hung on.”1
While there is a select group of individuals who resist the urge, most in-vestors sell their winning positions too soon, thus “cutting winners short,”and missing out on greater long-term gains.
Researchers have found the “cutting winners short” bias in simpleinvestment experiments. Professors Kuhnen and Knutson noticed thatsubjects in their Behavioral Investment Allocation Strategy (BIAS) taskwere more likely to switch to the “bond” in the next trial if they had pre-viously won $10 from a stock. There was no rational reason for subjects
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to switch to a more conservative strategy after a gain. Kuhnen notes that“this behavior indicates that people wanted to ‘conserve’ their gains and itresembles loss aversion.”2
According to some experts, selling winning positions too soon is a re-sult of “seeking pride.” Others believe that cutting winners short is drivenby the fear that one might lose what one has recently earned (“I don’t wantto give it back”). As we’ll see in this chapter, selling winners too soon isone side of the psychological bias called the disposition effect.3
THE DISPOSITION EFFECT
There is an old Wall Street adage: “Let your winners ride, and cut yourlosers short.” This saying is a warning against the cognitive bias of “lossaversion.” Loss aversion is characterized by a strong desire to avoid real-izing losses. People are more sensitive to the possibility of losing moneyor objects than they are to the possibility of gaining the same objects oramount of money. Loss aversion is at the root of a bias called the dispo-sition effect. Researchers use the name disposition effect to describe theapplication of loss aversion to investing. Investors who suffer from the dis-position effect inappropriately cut their winners short and let their losersrun.
Loss aversion is one tenet of the Nobel Prize winning theory of de-cision making called prospect theory. Propect theory is built on a foun-dation of simple psychological experiments that show how most peoplerely too heavily on frames, reference points, and anchors when makingrisky decisions. People perceive many ﬁnancial decisions in terms of theirframe—whether they are viewed as a potential loss or a potential gain.Reliance on frames and reference points causes systematic distortions indecision making. One tenet of prospect theory, loss aversion, explains thatpeople typically overweight the pain of losses twice as much as the plea-sure of gains when making decisions. Entire books have been written aboutprospect theory, and I cannot do it sufﬁcient justice in these few pages. Inthis and the next chapter I will summarize the effects of framing and lossaversion on ﬁnancial decisions, such as those of investors.
The concept of loss aversion is not easy to understand. In Chapter9 you read a study from Greg Berns at Emory University indicating that“dread” spurs individuals to take their losses as soon as possible. The“dreaders” paid money so that they could experience a feared electricshock sooner. On the surface, this result appears to contradict the dispo-sition effect, in which people essentially pay more to avoid taking losses.The fact is, in disposition effect experiments there is always a chance that
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the feared loss will not occur. When a loss is believed to be certain, as inthe Emory study in Chapter 9, then people will actually pay more to “get itover with.”
In the markets, because the future is uncertain, the gap between dread-relieving selling and loss-averse holding lies in one’s beliefs about how thefuture is likely to play out. Namely, if people think they have a chance tomake their loss back, then they will hold on. However, when strong emo-tions take hold, they overwhelm the prefrontal cortex and drive thinking.Strong fear, and the physiological effects of stress hormones, will predis-pose one to catastrophic thoughts of further declines and ﬁnancial ruin.If an investor thinks their position is hopeless, or the stress of holding alosing position has grown too intense, then they will impulsively cave in tothe sell urge. Panic selling occurs when further losses appear guaranteedor the tension of holding a loser has grown too high.
The disposition effect is particularly a problem for individuals who buyand sell investments based on price movements. When such investors arewatching their proﬁts and losses (P/L), and they are signiﬁcantly proﬁtable,they are more likely to see an uncertain future as dangerous to their wealth(potentially taking away their gains so far). When they are losing money inthe investment, they perceive the future as a chance to make back theirlosses.
A FATHER-SON STOCK SALE
Many factors inﬂuence who is susceptible to the disposition effect. An ac-quaintance of mine has been an executive at Cisco Systems since the early1990s. When he started his job, he recommeded to his father that he buysome Cisco stock. His father made the purchase, and by late 1999 his stockwas worth $7 million. The son had exercised his stock options in 1999, andhe too had multimillion dollars in Cisco stock. One day they had an impor-tant conversation.
The father said, “Son, I’m going to sell that Cisco stock. Seven million
dollars in the bank will change my lifestyle forever.”
The son said, “But Dad, if you hold on you’ll make even more money.”“I’ve seen this happen before in Silicon Valley,” his dad replied, “and Idon’t want to ride it down. With this money I can retire early and live thelife I’ve always wanted. Thank you for the tip.”
His son was puzzled and a little angry. He told his father, “You’ll regret
this decision. I know how great this company is.”
Of course the rest is history. The father now lives a relaxed and com-fortable lifestyle, while his son is still working at Cisco. The son is by no
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means ﬁnancially uncomfortable, but he still regrets holding on to all of hisCisco shares through the burst of the bubble.
Through the lens of the disposition effect, one could say that the fathercut his winner short, and he only looks smart in hindsight. Further, onecould say that the son held on to a loser too long. Of course, hindsight is20/20. In this case, how can one differentiate between biased and sensibledecision making?
The father recognized that the technology stocks were in an unsustain-able bubble. He had speciﬁc plans for the proﬁts, and he had achieved hisﬁnancial goals. He bought when Cisco stock was selling cheaply, and nowit was outrageously expensive. Every rally was seen as “gravy” (an unex-pected but welcome addition). He understood that when one’s ﬁnancialgoal is achieved, and one does not expect signiﬁcant further progress, it istime to change course.
His son, having less market experience, was unaware of the cyclicalnature of booms and busts. He had no sense of fair value for Cisco stock.Based on his limited experience, he expected this bubble to make himultra-rich if he only held on a little longer. For the son, every stock pricerally was expected and declines were terrifying.
For both men, it was their perspective that determined how they feltabout their wealth. For the father, once he surpassed his ﬁnancial goals,and the stock began to look overvalued, he was looking to sell. The son ex-pected gains into the foreseeable future, and he was dismayed by sidewaysor downward stock price action. When declines began, the son couldn’t ra-tionally factor the changing market conditions. The son was paralyzed byhis inability to accept the decline when it began. Rather than selling outwith an enormous proﬁt, his shares lost 90 percent of their value, and heheld on all the way to the bottom.
TEASING OUT THE PROBLEM
The following problems illustrate the psychological process of “aversion toa sure loss,” which often occurs during risky decision making and underliesthe disposition effect.
Ĺ Problem 1: Imagine that you face the following choice. You can accepta guaranteed $1,000 or take a risk. If you take the risk, the outcome willbe determined by the toss of a fair coin. If heads comes up, you win$2,000. If tails comes up, you win $0. Would you accept the guaranteed$1,000 or take the risk?
Ĺ Problem 2: Imagine you face the following choice. You can pay $1,000now and the gamble is over, or you can take a risk whose outcome will
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be determined by the toss of a coin. If heads comes up, you lose $0. Iftails comes up, you lose $2,000. Would you take the guaranteed $1,000loss or take the risk?
Of course, how you choose doesn’t really matter. Each option has thesame expected value. Yet even so, most people feel inclined to take theguaranteed gain in Problem 1 and take the risk in Problem 2. In a simi-lar decision situation, Nobel Prize winner Daniel Kahneman (working withAmos Tversky) found that 84 percent of subjects chose the sure gain inProblem 1, and 70 percent chose to take the risk in Problem 2.4
During my seminars, I’ve found that audiences consistently favor theguaranteed gain (78 percent) in Problem 1, while the majority takes the riskin Problem 2 (72 percent). As one professional trader pointed out, “I canfeel the inclination to reverse my choice between Problem 1 and Problem 2,so I assume it must be a problem.” He’s right. What feeling inclines peopleto reverse such decisions?
In any decision that involves a risk of loss, there is fear. The brain isexquisitely more sensitive to losses than gains—losses are weighted twiceas heavily as gains—and decisions that can be taken to avoid realizinglosses are prioritized. When operating with an existing gain (in the “gain”frame), the fear is that one will lose paper proﬁts. When operating underthe shadow of an ongoing loss, there is a powerful avoidance mechanism,also driven by fear. In the short term, the most ego-gratifying action fora paper gain is to sell for a proﬁt. Capturing the gain relieves the fear of“giving back” what one has already earned and sustains a feeling of self-satisfaction and pride. For a paper loss, the most ego-protective action isto hold on to the losing position, denying that it is a problem while hopingto “break-even.” Therefore, how investors deal with risk depends on thedecision “frame.”
In academic parlance, most investors are “risk averse in the realm ofgains” (so they cut winners short, preferring the certain gain), and they are“risk seeking in the realm of losses” (they prefer the gamble over the cer-tain loss)). In the case of losses, the decision to hold on to a losing stockis inspired by the same bias that inclines people to prefer the gamble overthe sure loss in Problem 2 above. The preference for the risky gamble is as-sumed to be “risk seeking” in the realm of losses, and it underlies investors’attempts to “dollar-cost average” into losers and hope for a “comeback.” Ineach case, loss-averse investors are trapped in the “frame” of seeing risksto their wealth, which biases their objectivity. Remember, loss-aversion de-scribes the psychological process that underlies the disposition effect (cut-ting winners short and holding losers too long).
Sometimes investors pump more and more resources into losing po-sitions. For example, the “sunk cost” bias refers to the phenomenon ofbusiness investors believing, “Since I’ve already invested so much money
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in this project, I might as well continue funding it until it pays off.” In real-ity, this thinking shows evidence of loss aversion. Many municipal govern-ments demonstrate this type of ﬂawed reasoning as more and more fundsare poured into overbudget and poor-quality construction projects (e.g.,Boston’s “big dig” highway project). The sunk cost bias is a result of hop-ing a losing idea will make a comeback, and it irrationally works againstthe retooling of moribund schemes.
FRAMING RISK
When a decision is explained as a potential gain, then the brain’s rewardpursuit system is engaged. When the decision is made in relation to whatone might lose, the loss avoidance system is activated. The differential ac-tivation of these two motivational systems depends on how one predomi-nantly sees the decision—as a potential opportunity or a potential risk. Thedifferent presentations of a decision, in terms of either what one might loseor what one might gain, is called framing.
Dan Ariely, when teaching psychology at Harvard, informed two of hisundergraduate classes that he planned on reading his original poetry toselected students. One class was asked if they would pay $5 to listen to10 minutes of his poetry, and if not, they were asked to write down a mon-etary sum that would sufﬁce. The other class was asked if they would take$5 to listen to 10 minutes of his poetry, and if not, they were asked to writedown their price. All students either offered to pay (in the ﬁrst class) or de-manded to be paid (in the second class). No one in either class wrote downa price of opposite sign (pay/take) from that presented. The expectationsof these students were anchored by the framing of the decision situationAriely presented.5
Framing studies show that how an investment is offered—think“golden opportunity” versus “risky and speculative”—skews decisionmaking. At its heart, framing is the psychological process underlying lossaversion. Investigators in London decided to look for the underlying neuralprocess.
A FRAME IN THE MEMBRANE
Neuroscientists in London designed an experiment that used framing toelicit the neural process underlying loss aversion. In an fMRI study atUniversity College London, Benedetto De Martino recruited 20 men andwomen to undergo three 17-minute brain scans. At the start of each trial,
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FIGURE 14.1 Transverse depiction of the amygdala.
the subjects were given English pounds worth about $95. They were thenasked to make a choice between either a certain outcome (a gain or a loss)or taking a gamble. The gamble they could accept was a simple 50–50 betin which they wagered a predeﬁned amount of their money. The gamble’sexpected value was equivalent to that of the certain option, so there wasno ﬁnancial reason why subjects should show a preference for either thecertain outcome or the gamble.6
When the choice was framed as a decision between “keeping” a cer-tain amount of money or gambling, most participants chose to “keep” theirmoney. For example, told they would “keep” 40 percent of the starting sumif they chose not to gamble (as in “Keep $38”), the volunteers typically
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FIGURE 14.2 Coronal depiction of the amygdala.
played it safe, choosing to take the 50–50 gamble only 43 percent of thetime. Told they would “lose” 60 percent of their initial pot if they didn’tgamble, they took the risk 62 percent of the time, even though the gamblesalways had the same expected value as the certain option. Interestingly,DeMartino’s results provide evidence that loss aversion is induced by thelanguage used to frame a risky choice.
The subjects had the odds explained to them in detail before the ex-periment, and they knew that the probabilities in each situation were iden-tical. Nonetheless, their decisions were altered by the language: “Keep $38”put them in a gain frame, and “Lose $38” induced a loss frame. Whensuccumbing to loss aversion, the subjects’ amygdalas (stimulated by dan-ger) activated vigorously. When participants resisted the framing effect,the orbitofrontal cortex (involved in integrating emotion and reason) andthe anterior cingulate cortex (responsible for sorting out internal con-ﬂicts) both activated. “We found everyone showed emotional biases, moreor less; no one was totally free of them,” De Martino said.7 Four of thestudy participants acknowledged that they had been inconsistent in their
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decision making, choosing according to the frame rather than the odds, andin explanation they said, “I know, I just couldn’t help myself,” according toDeMartino.8
In lower animals, the amygdala prompts “ﬁght-or-ﬂight” behavior in re-sponse to an immediate threat. When the amygdala is activated, peoplewill go to great lengths to avoid perceived threats to themselves or their re-sources (wealth). Figures 14.1 and 14.2 shows two views of the amygdala.
HOLDING LOSERS: “DOUBLE-OR-NOTHING!”
“Even being right 3 or 4 times out of 10 should yielda person a fortune if he has the sense to cut hislosses quickly on the ventures where he has beenwrong.”
—Bernard Baruch, Financier
Loss aversion has been found in many professional groups: stock in-vestors, real estate investors, and traders. As a group, no ﬁnancial profes-sionals are immune. In a year 2000 paper entitled “Do Professional TradersExhibit Loss Realization Aversion?” Locke and Mann studied the tradingpatterns of Chicago Mercantile Exchange (CME) ﬂoor traders. They foundthat the most successful traders exhibit less loss aversion: “Relatively suc-cessful traders are less prone to sit on losing trades.”9
In a 1998 study of individual
investors, Odean found that retailtraders hold their losers longer than their winners, leading to deterioratingproﬁtability.10 And in a 2005 study, researchers found that Chicago Boardof Trade (CBOT) traders who had morning losses take 16 percent morerisk in the afternoon, trading larger positions with decreasing proﬁtabilityafter lunch.11 Taking more risk when down is considered of the same ilk asnot selling a loser—in each case one should cut the loss short, not hold itor increase its size.
Not only are professional traders and individual investors sufferingfrom the disposition effect, but mutual fund portfolio managers are aswell.12 In other studies, investors have been found to display loss aversionin assets as diverse as real estate,13 company stock options,14 and futures.15When an investor monitors fundamental business values, then theprice of stock is meaningful only as an indication of a market discount orovervaluation. Great long-term value investors such as Warren Buffett andDavid Dreman buy businesses that the market has priced far below funda-mental value. After buying, they don’t sell their shares until the business isno longer priced at a discount by the market.
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DIFFERENCES IN AVERSION
The level of loss aversion is different from person to person, and withinone person it changes over time depending on recent events. Earlier, I men-tioned that, when given the chance to take a risky ﬁnancial gamble, mostpeople negatively value losses twice as intensely as they positively valuegains. The ratio of loss aversion is (2:1). The ratio 2:1 means that the av-erage “lambda” (the loss aversion coefﬁcient) is 2 (actually, the average isaround 2.5, depending on the situation). The lambda represents the amountby which the value of the avoidance of losses is overweighted (in expectedutility) versus the pursuit of gains.
In constitutionally anxious people, the lambda is over 6. They are soafraid of losses that the majority of these “high-lambda” individuals willnot take a gamble with even odds (a coin ﬂip) unless the potential gain ismore than six times as large as the potential loss.
Many great investors have low lambdas, just over one. They under-stand that a series of risks with favorable odds will lead to long-term re-turns. Pathological risk takers (such as problem gamblers) have lambdasless than one. They are willing to pay for the thrill of risk taking. Amongthose who have high lambdas, researchers have found that many do notlearn from their mistakes—as if loss aversion is a stable personality trait(such as neuroticism).
There can be many rationalizations that investors cite to support hold-ing their losers too long. There’s something about losing—maybe it’s thepain or the humiliation, the guilt or the shame—so that it’s difﬁcult to ac-cept the loss. And the most dangerous aspect of this tendency is that mostof us avoid admitting our losses even to ourselves.
One’s level of loss aversion (and thus one’s lambda) can change overtime. After experiencing a recent loss, most people become more lossaverse, as if the amygdala has become primed. Losses of any kind have thiseffect—the death of a loved one, illnesses, accidents, work-related losses,and trading losses all affect us similarly. Perhaps this is why faces withfearful expressions have a subliminal effect that reduces risk taking. Fol-lowing losses people will become more loss averse, conservatively stickingwith what they know to avoid