Financial theory starts with two key assumptions: first, that markets are efficient; second, that investors are rational. And, of course, in the real world, we all know that markets arenâ€™t perfectly efficient and that there is no such thing as a rational human being. The half-human Spock might have made a killing as a Wall Street trader, except that the Street died in 2008 and the Enterprise didn’t hit its time warp in 2063. Real humans laboring in the finance departments of this nationâ€™s finer universities have been trying to figure out just how markets are inefficient, and in which ways investors are irrational. Once we have that information, then maybe we can make money with it. The field is called behavioral finance.
Now, those of us who have lost gobs of money in our 401(k) accounts know just how hard it is to stay calm. Sure, money isnâ€™t everything and love of money is the root of all evil. Itâ€™s one thing to understand that intellectually, and another matter entirely to be able to open that statement from Fidelity without any emotion.
In March, Peter Sokol-Hessner of New York University and a group of five co-authors published a paper in the Proceedings of the National Academy of Sciences called â€œThinking Like a Trader Selectively Reduces Individualsâ€™ Loss Aversion.â€ In it, they use psychology to study the characteristics of effective traders. They start with the notion that professional traders understand that loss is part of the game, so they donâ€™t panic when things go badly. They just forge ahead to the next trade. (And then, after work, some of them go out and drink or do drugs or cheat on their spouses, but itâ€™s okay as long as they maintain focus at work!)
Traders live on maxims, and one of their favorites is that the stock doesnâ€™t know you own it. Itâ€™s just money, just blips on a screen, not friendship or loyalty or self-worth that gets traded. Back in my investment banking days, I liked the traders because you always knew where you stood with them. They were so busy concentrating on the market that they didnâ€™t have time for political games, a refreshing attitude in a corporate setting.
Sokol-Hessner and his colleagues ran different experiments with volunteers who were given play money and asked to place bets. One group was told to think about how they would feel about winning or losing before each round; the other group was told to pretend that they make financial decisions every day for a living and that their wins and losses were part of a larger portfolio of other wins and losses â€“ in other words, to think like traders. What they found was that the people who were told to think like traders did better in their play because they were less affected by losses, but they were still affected.
Losses hurt, whether they be financial or personal. I canâ€™t help with the personal stuff. On the financial side, though, it helps to remember that it is only money in your mutual fund account, not your self-worth. The markets come back, eventually; they always do.
Financial regulation is going to change as we work through the current crisis. It has to. For the new regulation to be effective, it has to accept that not everyone is rational and able to make good decisions all the time. We canâ€™t hand out Zoloft to everyone who wants to invest, but we can at least recognize that itâ€™s not enough to have disclosure in the finest of fine print.