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Buying stocks? Go to sleep, wake up rich

Last updated on: July 16, 2009 14:07 IST

How many times have you read that earning a good return is important, but not as important as being able to sleep at night? Investment guides typically advise you that feeling comfortable with investing is as important as earning a good return. I think that lets investors off the hook without doing their homework. Those who don't want to learn about investing can simply claim they have a low tolerance for risk.

The truth is that no one wants to lose money. Inexperienced investors see risk in very simple terms: If I invest $10,000, will I get my $10,000 back? If there is a chance that they might lose some of it, the risk is too great. For them, that's it for determining risk tolerance. And that limits those people to a handful of investments such as Treasury bills and money market funds.

But that's far too simplistic. Every one of us would like to put our money into something that is guaranteed and still grows at 15 to 20 per cent a year. That's simply not possible. Instead, you must weight all of the different types of risks you face with your money - including the risk that you won't have enough if you don't make some prudent investments.

That's because money has to grow to beat the risk of inflation. So, if your risk tolerance is too low for your own financial good, you must do something to increase it. Perhaps learning more about investing might help. Or making a few small investments to get comfortable with the idea of putting money in stocks.

Risk tolerance is still a fuzzy concept even among investment professionals. But professionals are busily immersed in a hot new specialty area of economics called behavioral finance. I think there are some nuggets of wisdom here for novice investors that might shed some light on risk tolerance. So bear with me for a brief rundown on some of the issues.

To understand behavioral finance, we have to take a step backward to what the economists call standard finance. Standard finance assumes that people act in a rational way to achieve what is in their own best interest. Now on the face of it, that seems to make sense.

The problem is with how the economists define rational. Their idea of rationality assumes that we all know a great deal more about finance than we do. It also assumes that we ignore issues of fairness and many other emotions that motivate most people.

Let me give you just one example. Suppose you and John are asked by an economist to participate in an experiment.  You are told that you are to split $100 between yourself and John in a manner that will be acceptable to John. If John accepts your split of the hundred bucks, you and John keep the money. If John turns down your offer, the economist keeps the $100.

What do you offer John? Well, I read about this experiment, or "game' as the economists call it, when I first began researching behavioral finance. It looked like an easy problem to me. Are you ready with your answer? The correct answer is: You offer John one penny. If John is a rational man, he will take the penny, realizing that that is more than he otherwise would have had. And, of course, since you are a rational person, you are offering him only a penny.

Why should you offer him any more than you have to if you are acting in your own best interest? Well, I was totally bowled over by this game. I suspect most people would just give John $50.  Both you and John would be better off.  And it would be fair. So this is what the economists consider rational.

Over the past several years, a group of economists has begun to poke holes in standard finance. These behavioral economists argue that people are not rational with their money: that there are many anomalies in the way they invest.  Well, anyone of us who is not a mathematician or an economist could have told them that some time ago.  But their studies provide some­thing of value.

Because economists look at the irrational ways we invest from an objective point of view and group them into certain patterns, looking at behavioral finance can teach us something about our mistakes.

Much of the work in behavioral finance has to do with the irrational way investors view risk. For example, Dr. Amos Tversky, a pioneer in the field who died in 1996, along with Dr. Daniel Kahneman at Princeton University, described what they called "prospect theory.' The two researchers found that investors feel much more pain when they lose $1 than they feel pleasure when they gain $1. (Under the old view, of course, a rational person would have been assumed to view the gain or loss of $1 equally.) Yet Tversky and Kahneman found that most of us are actually willing to take more risk to avoid a loss than we are willing take to achieve a gain.

Dr Meir Statman at Santa Clara University has done considerable work on what he calls the "fear of regret." Investors feel sad and foolish when they make an error in judgment, Statman says, "I can certainly attest to that.  So can you if you've ever bought a stock or a mutual fund based on a tip from a friend and then watched it plunge.

Likewise, when you sell a stock or a mutual fund, do you watch the price in the paper and pat yourself on the back if it goes down or kick yourself if it goes up, second-guessing your decision to sell?"

Well, Dr Statman argues that these emotional feelings affect the way you invest. He's right, too. For example, many investors buy a stock and then, if it goes down, refuse to sell it, even if they can see that it may well decline further.  Why?  It's embarrassing to admit their mistake. It's not just novices who do this. Much of the real damage is done by professional money managers who would rather buy a popular company that everyone else is buying than take a chance on an unpopular one, be wrong, and feel foolish.

That's why it's so hard to find a mutual fund manager with conviction and the courage to take a stand. And why it's so easy to find index huggers - those managers who buy lots of the same stocks that everyone else buys. Statman also shows that sophisticated investors - executives, members of boards, securities analysts - believe that the stocks of "good companies," or those that produce quality products and services and employ superior managers, are better long-term investments than the stocks of "bad companies."

Why do we let our emotions intervene when we invest our money? I don't feel regret when I buy a rug or pay a doctor bill or fill the car up with gas. Do you? So why do we load all this passion and emotion into investing? Why do we expect all this romance from our investments? Why do we want to read about what our portfolio manager does on Sunday afternoons?

Now Dr Statman, a charming man I had lunch with at the Sir Francis Drake Hotel in San Francisco one November, Sunday in 1997, does not make any of these mistakes. He believes the only way to avoid them is to buy index funds.  For most of us, Dr Statman's solution is a good one. For all of us, his work and the work of other behavioral economists should help to pinpoint some of the investing mistakes that leave us poorer and sadder.

Most importantly at the moment, how should we be looking at risk?  Investment professionals see time horizon as one of the biggest factors in determining risk tolerance. If you have 10 or 20 or 30 years to invest your money, you can afford to be a big risk taker.

In fact, you can't afford not to take risk if what we mean by risk is volatility or fluctuation in value. To earn a decent return, you must learn to live with some volatility. Even if you don't invest at all, you still take on plenty of risk: the risk that your savings won't grow enough so that you can do the things you want to do in the future, like buy a house, pay for college for your kids, or have a comfortable retirement.

Dr Richard Thaler, a behavioral economist from the University of Chicago, describes the perfect investor as Rip Van Winkle. He buys stocks. He goes to sleep for 20 years. And he wakes up a rich man. Try to remember that when you invest. Don't watch your stocks or stock mutual funds every day. Don't be influenced to trade by articles you read on the "hot funds to buy now". Develop a plan, invest, and then play Rip Van Winkle.

Just because an investment is risky doesn't mean it's a good one, though. Some risky investments are just plain foolish. And some people who sell them are looking to make a quick buck at your expense. Lots of people jump at every opportunity to take a risk without even considering whether they stand a chance to do well with the investment.

[Excerpt from The New Commonsense Guide to Mutual Funds ( Published by Vision Books.]

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