RISK-TAKING BEHAVIOR

Behavioral economics, which is a hybrid between psychology and economics, has always fascinated me.  The current sell-off in the stock market got me thinking about how there are so many similarities between stock market investing and horse-race betting in terms of how participants tend to react to risks from gains and losses.

Experiments in prospect theory, which focuses on behavioral biases that lead to sub-optimal decision making, have shown that people are predisposed or hard-wired to be risk averse (prospect theory was pioneered by Nobel Laureate Daniel Kahneman and Amos Tversky).  A key finding that pertains to all forms of risk taking is that people feel more emotional pain from losses than they do emotional gratification from gains of the same amount of money.

A horse-race bettor, for example, is likely to experience more regret, a negative cognitive emotion, over a $100 losing wager than fulfillment from a $100 winning bet. Regret often leads to and reinforces risk-averse behavior.  A former neighbor of mine once told me that when he went to the local racetrack for his first and only time, he did not cash a bet.  He said he was never going back, evidently risk averse to an extreme over his lack of success in a single day of pari-mutuel wagering.

During the current stock market sell-off, I heard an investor, who is about 50 years old, say he sold most of what he owned, even though he still has substantial double-digit gains over the past five years.  Here again, the individual became risk averse and also focused on what is occurring now (the recency effect) rather than thinking rationally about his long-term returns.

On average, since 1980, there has been an annual market correction of at least 14%, so what is transpiring is normal stock market behavior (although until 2022, the S & P 500 had never declined by more than 10% to start a new year). Warren Buffett’s Berkshire Hathaway has been down 50% at least twice in its history, yet has produced phenomenal returns for investors who stayed with it through peaks and valleys.

As human beings, even the most experienced and skilled among us are subject to emotional reactions to risk-taking, whether it is betting on horses and sports or what to do with our stock portfolio.  Intellectually and empirically, we know long-term trends, but struggle to avoid making poor decisions owing to pangs of regret over losing blips.

I have to go now to find a diversion, perhaps betting a few horse races, from what is happening to my stock portfolio, so I can avoid the urge to sell, sell, sell!

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