Sunday, March 18, 2007

Sunday dollars+sense: Are successful investors not quite the full quid?

What’s the secret of investment success? Part of it could be brain damage. Most of us are notoriously and unreasonably cautious when it comes to taking risks.

Try this: Toss a coin. If it comes up heads, I’ll give you $250. If it doesn’t, you will have to pay me $100. Not prepared to take me on? You should. The odds favour you.

Perhaps that’s because there is too much money at stake. What about a series of smaller bets? What if I give you 20 one-dollar coins. If you want to you can toss each one of them. I’ll turn it into $2.50 each time it comes up heads, and you will lose if it comes up tails.

Researchers from Stanford University have found that around 80 per cent of people accept the bet at least once, but only 50 per cent accept it on all of the time. Which is odd, because accepting the risk all of the time is the best way of making money.

Then researcher Baba Shiv and his colleagues played a hunch...

They performed the same test on a group of Americans who had suffered a stroke or survived brain surgery. All had a damaged prefrontal cortex, the part of the brain that processes emotions.

The brain-damaged Americans turned out to be much better investors than the Americans with their brains intact. Given the same $20 each and the same 20 chances to accept the attractive bet, 83 per cent of them accepted all the time. They made more money than did the Americans with the emotional part of their brains intact.

When the study was published in the Journal of Psychological Science in 2005 one newspaper headline asked: "Are successful investors emotionally brain damaged?" Another declared: "Psychos best investors".

But being fearless isn’t always the best way to make money. As it happened several of the brain-damaged volunteers in the study were bankrupt. Being wary is good for us much of the time because it prevents us being taken advantage of. The important finding is that people with normal brains tend to be wary even when they shouldn’t be.

One secret of investment success might be to outsource your investment decisions to someone who isn’t wary. Superannuation fund managers take large but well-calculated risks all the time. They do it without emotional attachment, because it is not their money.

Investment Behavior and the Negative Side of Emotion
Shiv, Baba; Loewenstein, George; Bechara, Antoine; Damasio, Hanna; Damasio, Antonio R.
Psychological Science, Volume 16, Number 6, June 2005, pp. 435-439