Let's think about emotion and the role it has in investing. We talked about loss aversion, overconfidence. Can we provide some additional evidence on the role emotion has on investing? It should be key to behavioral biases, emotion, the psychologies, what's behind some of these behavioral biases we talked about. If behavioral biases are a detriment to performance, then it raises a natural question, are psychopaths the best investors? This was an interesting article published in Psychological Science here by scholars at Stanford, Carnegie Mellon, and Iowa where they actually do an experiment with actual psychopaths to see, do they make better financial decisions? Is this who you want as your financial advisor at the end of the day? Let's see what the evidence is. The role of emotion in financial decisions, let's consider this experiment. You start with $20, 20 sequential and independent rounds of gambles. There's going to be 20 gambles, each of them is independent. For each gamble, it's like flipping a fair coin. You can pay $1 to participate in the flipping of the coin, and then you're either going to win $2.50, or you get back 0. There's 20 gambles, you have $20. To participate in each gamble, you have to pay $1. Then you're either going to get back nothing, or you're going to get back $2.50. Let's think about this gamble here. What would we do? What is the expected payoff from this gamble? Remember, we pay $1 and than, we either get 0 or $2.50 back. How many times out of 20 would you do the gamble? You can do this gamble 20 separate times. How many times would you do it? Finally, whether you won or lost last round, whether you got 0 or $2.50, should it affect whether you gamble the next round? As a fourth question, I wanted to ask, are you yourself a psychopath? I decided probably best not to do that. Let's think about these three questions. Keep the psychopath answer to yourself and then I'll give you my take. Let's just go through the simple math on the expected value of these gambles here. First, what's the expected payoff per gamble? In expected value, we'd get $1.25, the average of $2.50 and 0 is $1.25 minus $1 we spent for the gamble, that's a $0.25 payoff each time we flip the coin. How many times out of 20 would you do the gamble? Given the positive expected payoff, you'd say gamble it every time because this is a good deal. You can actually do the combinatorics. If you gamble each of the 20 rounds, it's easy to calculate the expected wealth as $25, $0.25 payoff times 20 rounds is $5. You started out with 20, so $25 is your expected wealth. Also, you can do the calculation a little more complicated. There's only a 13% chance of losing money, if you gamble each of the 20 rounds. There's only a 13% chance you end up with less than $20, if you gamble all 20 rounds. Since all the gambles are independent of each other, what happened last round should not affect your gambling or investment decision for the next round. But you can see this is where psychology may enter in to the decision. But given these are independent, we would predict that people who don't have emotions should basically be gambling each round, regardless of what happened the last round. Let's think about three groups of participants to use for this study to test whether emotions affect financial decisions, at least, in this experimental context. Group one, the psychopaths. What do we mean by psychopaths? They have a brain lesion that short circuits their emotions, so any behavioral finance story shouldn't apply to them. Because they don't have any of this emotion, feeling bad, realizing losses, that would be key to a lot of behavioral finance. What's group two? We'll call them normal folks, in that they don't have any brain lesions. This is the part where I can say, wow, these are like, serious academics going above and beyond to control in this experiment. Let's have a third group, the individuals that also have brain lesions, but unlike psychopaths, the brain lesions are in a part of the brain that doesn't short circuit emotion. The three groups are psychopaths, brain lesion that short circuits emotions, people with no brain lesions, who we'll just call the normal folks. And then the third group is individuals with brain lesions but it doesn't affect their emotions. Let's consider three potential behavioral biases in decisions. Loss aversion, we talked about that earlier in the module. A house-money effect. House-money effect is, maybe, if you've gambled it all, you should think money as money whether I earned it at work, whether I got it as interest in my bank account, whether grandma gave it to me or whether I won at a casino, money is money. But the house-money effect would suggest money you won, you might view differently that money you came into the casino with. Maybe I win at the casino, I'm more willing to be more risk loving. Somehow I view it as free money or money I didn't really earn, so maybe I'm more willing to gamble with the house-money, money I've won at the casino than I would be with money I brought in myself. That's a house-money effect. Finally, we talked about representativeness in Module 2 in the context of people's decisions in their retirement plans. Do we think people maybe extrapolate past performance into the future? Now, even though these are independent flipping of coins, you still might think hey, I just think there's trends. I got two heads in a row, I bet the next one will also be heads, I'm on a hot streak. Let's bring Le Penseur. Time to think about what are the predictions that would come with each of these three behavioral phenomena in terms of, are you more likely to gamble if you won or lost in the prior round? Do you expect people to be more likely gamble if they won the last round or if they lost the last round under these behavioral biases? Let's think of loss aversion, then let's think of the house-money effect and then let's think of representativeness. Consider for each of these, are people going to be more likely to gamble if they won or lost the last round? Think about it for each three of these behavioral biases and then I'll give you my take. Do you expect people to be more likely to gamble if they won the last round or if they lost the last round under these three behavioral biases? Let's just take them one at a time. First, loss aversion. I think here the prediction would be that if you have lost last round, you feel like I'm in the hole, that makes you more risk-loving. That would suggest hey, I'm willing to gamble more to try and get out of the hole. I've lost up to this point, I just want to continue to gamble, so I can break even, get back to the $20 I went in with. Or if I won last round, then I'm above $20, I feel good, maybe I want to stop gambling. I think the prediction under a loss aversion, you're going to be more likely to gamble in the future if you've lost in the prior round, than if you've won and this actually explains my behavior. Gambling once at Foxwood's casino in Connecticut, I went in with $20, I probably lost $5. I'm playing $0.50 slot machines. I put in the $0.50, all of a sudden, $40 of quarters comes pouring out. Done! Haven't gambled since. I leave a net winner in terms of my visit to the casino. This loss aversion effect, me realizing the gain, I win, I stop, then I'm done. So that would describe me, but maybe not the typical person. House-money effect. Here, the idea is you've won in the past, now you have your original $20 you came in with. You have some additional money from your winnings. With that additional money, it makes you more willing to gamble in the future because you view that as free money. So you're very risk-loving, you throw caution to the wind. The prediction for house-money, If you won last round, you continue to let it ride, you gamble in the future. Where if you lost last round, then you maybe are becoming more conservative, less likely to gamble and a similar predication for representativeness. That's just extrapolating the past into the future, so if you've won last time, then you're like hey, I think I'm on a hot streak, let me continue to gamble. Where if you lost last time, I'm cold, let me just stop gambling here. Although, of course, this hot or cold doesn't make any sense because it's just totally independent flipping of the coin. Let's actually just see the results from this experiment that were published in Psychological Science. We have these three groups. Psychopaths, the normal people which I just want to emphasize I am just putting in quotations marks. It is a shorter way to write it than people without any brain lesions, but that is really what is in the second group. The third group of people, they have brain legions but it's not affecting emotions. We're looking at what fraction of the time do they do the gamble. Our prediction is you should do it 100% of the time. And then really interesting is to look at what is the amount of time they gamble when they have won the last time, versus the percent of time they invest or gamble when they lost the last time. So really interesting to look at is not only what fraction of the time do they gamble or invest, but are there any differences whether they won last time or they lost last time? Let's look at the results. Frst, we start out with the psychopaths. They're not investing 100% of the time but they are investing 84% of the time and actually, their average wealth there, at the end of the experiment was $25.70. These guys actually, on average, had a little good luck, right, because if you invested 100% of the time, your average wealth would be $25. They invested 84% of the time, they took the gamble 84% of the time, and their average wealth was actually a little more than $25. So they just happened to have some good luck when it came to flipping the coin, but another reason their wealth is much higher than the $20, is they gambled a lot. But particularly interesting for these psychopaths, look at this likelihood of gambling if they won last time versus they lost last time. It's identical, 84%, 85%. This is key, this did you win, did you lose last time, does it affect your subsequent decisions? Economically, we'd say no, it shouldn't, and the psychopaths are behaving perfectly that way. Maybe anyone who's had an economic class says, I'm not surprised. It seemed like most of the economics professors I had seem like psychopaths. How about column two? These are the people without brain lesions, so they are influenced by emotion. They're only gambling 58% of the time. They end the experiment with lower wealth than the psychopaths. But look at this interesting breakdown. They're much more likely to gamble if they won last time than if they lost last time. If they won last time, they'll gamble 62% of the time. If they lost last time, they'll gamble 41% of the time. It seems like this would be consistent with the belief in a house-money effect, or consistent with a representativeness, like the extrapolation of I have hot hands, so let me continue to gamble. Now the third control group. Maybe there's just something different with people who have brain lesions. Let's look at another group of people that have brain lesions like the psychopaths, but they're different. The brain lesion is in a different part of the brain, so emotions are fine, just something else is affected. For the third group, they are behaving pretty much like the quote, unquote, normal people that don't have brain lesions. They're investing their wealth 61% of the time, much less than the 84% of the psychopaths, and very similar to the 58% of the people without brain lesions. It's just unfortunate for the third group that they're investing 61% of the time. So just a simple expected value would be they should have $23 of wealth at the end, but unfortunately, they only have $20 of wealth. So it's like bad draw, I have a brain lesion plus I had a bad luck with the flipping of coins, or probably if I am contributing 60% of the time, I expected wealth should be 23. It turned out to be 20, so they just had bad luck with the flipping. They also had this dramatic difference, like the people without brain lesions here, if they won last time, their likelihood of gambling is 75%. But if they lost last time, their likelihood of gambling is only 37%. Again, for those who have brain lesions but it's not affecting emotions, they act just like the people without brain lesions. Both groups, emotions are fine. They seem to be subject in this experiment to either, representativeness like believing in hot hands, extrapolating the past performance into the future. Or they are subject to the house-money effect that they become more risk-loving if they've won in the prior round. You see here who is doing the best job with this experiment, it's clearly the psychopaths here, group one. They're investing a lot, which they should because it's a good investment and they are investing whether they won or lost last time. This raises a natural question. Who do you want as your financial advisor? You might think, I want someone like my surgeon, I want someone there with steady hands, that isn't going to be subject to emotion. Do you want to have the psychopath as your financial advisor? You might want someone who isn't making emotional decisions. If you do go this route, I just recommend one thing. Do your business over the phone.
