Dear Readers,
Last week I had the privilege of hearing Daniel Kahneman speak. Although his name might not be a household word, he probably understands more about how households make investment decisions than anyone else: Kahneman is one of the pioneers of a relatively new branch (30 years old) of economics called "Behavioral Finance." For his groundbreaking work, Prof. Kahneman was awarded the Nobel Prize in Economics last year.

While classic economic theory is based on the assumption that we are perfectly rational when we make financial decisions, behavioral finance knows better. The growing number of behavioral finance adherents focus on how human nature leads us to make less-than-rational economic choices and how this affects our investment results.

For instance, I bet you have different "mental accounts" for your money. You might have the "My Kid's College Fund" account, the "Saving for a Second Home" account, the "Emergency Expenses" account, "This Year's Vacation" account, a couple of "My Retirement" accounts, and so on. And you wouldn't think of dipping into your "Second Home" account to help pay an unexpected bill that exceeds what you've set aside in your "Emergency" account. Instead, you're probably inclined to put the overage on a credit card.

This kind of behavior might seem completely sane to you, but it runs counter to the basis of mainstream economics. To a classical economist, it makes no sense to segregate money this way. After all, a dollar is a dollar. We should be just as willing to spend "Vacation" money as "Emergency" money. And using credit at -- gasp! -- 18 percent interest rate is totally insane when we could easily come up with the cash by raiding another account.

But, of course, this is not how most of us act. We would never even consider withdrawing money out of a child's college education fund in order to help pay the cost of fixing a leaky roof. We call this "discipline." But when you think about it, we're really playing mental games to keep from spending money we know we're going to need some day. In fact, we "lock up" our savings in things like IRAs so we won't be tempted to use them for another purpose.

Oh, that's another thing. According to classic economics, we should have no trouble saving -- for any purpose -- because it is rational to calculate and then simply accumulate the money needed for, say, a child's college education. But, in reality -- which is where behaviorists dwell -- we know all too well how difficult this is. Human nature, in fact, leads us in the irrational direction of spending those dollars today for immediate gratification.

Kahneman and Amos Tversky, who died several years ago, were astute students of actual, not theoretical, behavior. Together they developed the founding principle of behavioral finance, which is called "Prospect Theory." Their work was published in the March 1979 issue of "Econometrica." Prospect Theory starts with the assumption that people are not perfectly rational in the choices they make, especially when it comes to accepting risk.

Prospect Theory demonstrates that the way our mind "frames" a decision and the way we mentally categorize the potential outcomes will influence our attitude about risk. It explains why people who are unwilling to accept risk in some situations, are willing -- even eager -- to take on risk in others. Why, for instance, you might invest your daughter's college money in CDs, but invest your retirement money in tech stocks.

Don't think you're susceptible to this? Take this little quiz:

1) Imagine that you have just won $1,000. Now you must choose between one of the following:

a. A guaranteed win of $500, or

b. Heads you win $1,000 and tails you win nothing.

If you're like most people, you go for the sure thing, option "a", the "safe" route. Even though they have a 50% chance of winning twice as much under option "b," most opt for the "guaranteed" return rather than risk any chance of a loss.

Now consider this next question:

2) Imagine that you have just won $2,000. Now you must choose between one of the following:

a. A guaranteed loss of $500, or

b.Heads you lose $1,000 or tails you lose nothing.

Most people choose b. This seems the "safe" choice. We'd rather take a chance of losing twice as much, for a chance of avoiding any loss at all.

The astute observer will realize both questions present exactly the same potential outcomes: under Option "a" you're guaranteed to end up with $1,500. Option "b" gives you a 50% chance of ending up with either $2,000 or $1,000, depending upon the outcome of the coin toss. Option "b" is therefore "riskier."

So why would someone choose the "safe" answer in one question and the "risky" answer in the other?

Kahneman and Tversky's groundbreaking insight is that it comes down to how the choice is framed, coupled with our acute aversion to "loss." In a nutshell: it is human nature to want to avoid losses. Others, following in the footsteps of Kahneman and Tversky have actually quantified this. To be exact, a loss of "Magnitude X" is 2.5 times more painful than the joy we get from a gain of "Magnitude X."

Since we hate losses so much, we will accept a higher level of risk for the potential to avoid any loss.

Which explains why folks love those "guaranteed" returns they get on CDs, even though potential -- though not guaranteed -- returns on investments such as stocks, are historically much higher.

It also explains why we hate to sell stocks that are worth less than what we paid for them. Even with the inducement of an economic benefit -- a tax deduction -- if we sell, we refuse to do so. We tell ourselves, "I'm going to wait until I break even." As a result, we end up selling our winners and hanging on to our losers! Perfectly irrational. And perfectly human.

Here's another example, classic economics assumes the rational investor uses all available information and makes decisions unbiased by emotion. Ha! The stock market high-tech bubble is a perfect example of why, in real life, this is not the case. Rational investors don't pay 150% times earnings for a stock. But look at all of the folks who did -- even professional money managers couldn't help themselves. In fact, everyone from the guy at the office water cooler to so-called Wall Street "gurus" could give you perfectly "rational" reasons why this made sense.

Behavioral finance calls this the "herd" effect. It's simply human nature to want to be part of the crowd. It feels good. After all, when everyone at work is chatting up their hot-dot stock or mutual fund investments, don't you want to be part of that? Anyone who talked about the benefits of bonds (eeeek!) in the late 1990s was a weirdo, a bore, someone you walked away from at a party.

The fact is, while we all glibly chant the mantra of "Buy low, sell high," it is incredibly difficult to do. After all, if you're "buying low," by definition you're buying something most other people don't want. Instead, we'd rather "Buy high," i.e. after the price has been bid up, because it feels better to be going with the crowd as opposed to against it.

Which explains why record amounts of money continue to pour into bond funds despite the basic axiom that bonds lose value when interest rates go up. Since we're at a 41-year low on interest rates and even pessimists have to admit rates cannot go much lower (we're already at 1.25% on the fed funds rate), eventually interest rates are going to head higher. Yet, investors stung by three years of stock market declines are now convinced bonds are "safe," (after all, everyone else is buying them, right?) so they're flocking to them, even though bonds prices are currently quite high and are sure to head lower when interest rates rebound.

Fact is, it's not easy to be a contrarian. Just smart. Warren Buffett is a billionaire many times over because he is able to separate his emotions from his investment decisions. Not a bad role model.

Here's to being human!

Gail

 

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The views expressed in this article are those of Ms. Buckner or the individual commentator, and do not necessarily reflect the views of Putnam Investments Inc. or any of its affiliates. You should consult your own financial adviser for advice regarding your particular financial circumstances. This article is for information only and is not an offer of the sale of any mutual fund or other investment.