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Why is it important to discuss emotion in a chapter on portfolio selection? Emotions determine tolerance for risk, and tolerance for risk plays a key role in portfolio selection. Note that investing takes place along a time line. In short, investors experience a variety of emotions as they:
- ponder their alternatives,
- make decisions about how much risk to bear,
- ride the financial roller coaster while watching their decisions play out,
- assess whether to keep to the initial strategy or alter it, and
- ultimately learn the degree to which they have achieved their financial goals.
Psychologist Lola Lopes (1987) identifies the major emotions along the time line and discusses the way that these emotions influence risk bearing. According to folklore, greed and fear drive financial markets. But this is only partly correct. While fear does play a role, most investors react less to greed and more to hope. Fear induces an investor to focus on events that are especially unfavorable, while hope induces him or her to focus on events that are favorable. In addition to hope and fear, that apply generally, investors have specific goals to which they aspire.
To what kind of goals do investors aspire? Typical goals include purchasing a home, funding children's college education, and having a comfortable retirement.
Think of the emotional time line as a line where time advances from left to right. Investment decisions lie at the left, and goals lie at the right. Investors experience a variety of emotions along the time line as they make decisions at the left, wait in the middle, and learn their fate at the right. Hope and fear are polar opposites, one positive and the other negative. Picture positive emotion above the time line and negative emotion below it. What happens above the time line as time progresses from left to right? Hope becomes anticipation and is then transformed into pride. Below the line, fear becomes anxiety and is then transformed into regret. You may recall from chapter 3 that Harry Markowitz talked about the importance of regret when planning his own retirement, saying "my intention was to minimize my future regret." [Money magazine, January 1998, p. 118.]
Hope and fear affect the way that investors evaluate alternatives. Fear causes investors to look at possibilities from the bottom up and ask, How bad can things get? Hope gets investors to look at possibilities from the top down and ask, How good can it get? In Lopes's terminology, the bottom-up perspective emphasizes the desire for security, whereas the top-down perspective emphasizes the need for potential on the upside. Lopes tells us that these two perspectives reside within all of us, as opposite poles. But they tend not [to] be equally matched: One pole usually predominates.
Barbara O'Neill (1990) has compiled an interesting collection of financial planning cases. The title of her book is How Real People Handle Their Money. Here is an example from her casebook, describing the situation of one particular couple, Barbara and Leon Smyth.
If they lived in a big city, instead of a rural area, you could probably call them "yuppies." Barbara and Leon Smyth, ages 35 and 37, are a two-career couple who earn a combined $45,300. They have a son, aged 14, from Leon's previous marriage. . . . Like many married couples, the Smyths have different attitudes about money. While Barbara is most concerned about safety of principal, Leon's major objective is future growth and he says he's willing to assume some risk to achieve financial gain. [Case study # 21]
The dominant emotion in Barbara is fear, and it leads her to emphasize security. For Leon, the dominant emotion is hope, and it leads him to emphasize potential. One of the great contributions of Lopes is to establish how the interaction of these conflicting emotions determines the tolerance toward risk. If there were one important point to take away from this chapter, this would be it!
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What Is Behavioral Finance?
Wall Street Week with Louis Rukeyser panelist Frank Cappiello once explained that because of a "change in psychology," but "no change in fundamentals," he altered his stance on the market from positive to neutral. Cappiello has plenty of company. The popular financial press regularly quotes regularly quotes experts and gurus on market psychology. But what do these experts and gurus mean? The stock answer is, "greed and fear." Well, is that it? Is that all there is to market psychology?
Hardly. Our knowledge of market psychology now extends well beyond greed and fear. Over the last twentyfive years, psychologists have discovered two important facts. First, the primary emotions that determine risk-taking behavior are not greed and fear, but hope and fear, as psychologist Lola Lopes pointed out in 1987. Second, although to err is indeed human, financial practitioners of all types, from portfolio managers to corporate executives, make the same mistakes repeatedly. The cause of these errors is documented in an important collection edited by psychologists Daniel Kahnemen, Paul Slovic, and the late Amos Tversky that was published in 1982.
Behavioral finance is the application of psychology to financial behavior—the behavior of practitioners. I have written this book about practitioners, for practitioners. Practitioners need to know that because of human nature, they make particular types of mistakes. Mistakes can be very costly. By reading this book, practitioners will learn to
- recognize their own mistakes and those of others;
- understand the reasons for mistakes; and
- avoid mistakes.
For many reasons, practitioners need to recognize others' mistakes as well as their own. For example, financial advisers will be more effective at helping investors if they have a better grasp of investor psychology. There are deeper issues too. One investor's mistakes can become another investor's profits. But one investor's mistakes can also become another investor's risk! Thus, an investor ignores the mistakes of others at his or her own peril.
Who are practitioners? The term covers a wide range of people: portfolio managers, financial planners and advisers, investors, brokers, strategists, financial analysts, investment bankers, traders, and corporate executives. They all share the same psychological traits.
—from the introduction to Beyond Greed and Fear