We are all gripped by fear from time to time, but as persuasive as fear can be, it’s not a good investment guide. For example, few accidents are more horrifying than airplane crashes, yet the fear elicited by such disasters depresses stock beyond reason. Aviation disasters, on average, cause actual losses of less than $1 billion, but the loss in the value of stocks following a major plane crash averages more than $60 billion.
Fear misleads us to avoid risk even when it is wise to take risk. Here is a telling investment game that illustrates this point: I’ll toss a coin. If it comes out heads, I’ll pay you $1.50. If it comes out tails, you’ll pay me $1.
We’ll play 20 rounds of this game. Before each round you can choose to participate or sit it out. Ready? Suppose that you have lost three dollars in the first three rounds because all three tosses came out tails. Do you choose to participate in the fourth round or do you choose to sit out?
Three losses in a row would arouse fear in normal investors. Many would choose to sit out the fourth round. But there is no good reason to be afraid because the game is stacked in favor of those who play all 20 rounds. In each round we have a 50/50 chance to lose $1 or gain $1.50. Our maximum loss is $20 while our maximum gain is $30. And even if we lose, a $20 loss is hardly catastrophic. And yet when the same experiment was run with brain-damaged patients, they were actually more rational about the odds than “normal” players. Undeterred by fear, they played more rounds of the game and won more money.
There is a lesson here for investors. Fear grips us when we watch our portfolios day by day and witness so many losing days. Fear grips us even more profoundly when we watch losses in our portfolios over many months or even years, as happened in 2008 and early 2009. Fear urges us to sell our stocks and invest the money in gold or stash it under a mattress. Our emotional response may be normal, but it often gets in the way of wise — and potentially more profitable — behavior.
