When Not to Trust Your Instincts

When making investment decisions, your gut isn't always your best guide.
Magazine Contributor
3 min read

This story appears in the February 2006 issue of Entrepreneur. Subscribe »

Looking to make better investment decisions? Going a little psycho might help, suggests a new study.

When researchers from the Stanford Graduate School of Business, Carnegie Mellon University and the University of Iowa compared investment decisions made by people with a diminished capacity for emotion to those of normal participants, they found that "functional psychopaths" make better investment decisions.

"To gauge the impact of emotions on investment decision making, we tested patients whose emotional circuitry had been impaired due to an accident or a stroke," explains Baba Shiv, an associate professor of marketing at the Stanford Graduate School of Business and co-author of the study.

The study's participants were each given $20 and told that they would be making a series of investment decisions. In each of 20 rounds, they had the option to invest $1 on the outcome of a coin flip--heads meant losing the dollar, and tails meant recouping $2.50.

"The idea was to simulate the market reality in the sense that making an investment seems risky, but overall you will be better off investing in every round," explains Shiv, who notes that investing in every round of the coin toss yields only a 13 percent risk of ending up with less than $20. "That correlates to the stock market in the sense that historical evidence suggests investors are better off investing in the stock market long term. Yet people have a tendency to pull money out and put it in low-interest investments as soon as they lose money."

Of the 41 participants, the 15 with impaired emotional capacity took the most logical approach to the game, investing in 84 percent of the rounds and ending up with $25.70 on average. Normal participants invested in just 58 percent of the rounds and ended up with an average of $22.80. "People generally started off making the right decision and then either lost once or twice and got scared, or won and wanted to protect those winnings," explains Shiv. "The patients with damaged emotional circuitry made rational decisions because they were not caught up in the outcome of the previous round."

The take-away for investors? Some people are naturally less emotional or more able to suppress their emotions, says Shiv, who suggests that those who tend to be emotional may want to leave the management of their investment decisions to a trusted third party. "Participating in an investing group and adopting a long-term mind-set toward investments can help minimize the risk of an emotional reaction," he says. "You can also shield yourself against being affected by outcomes by monitoring investment performance on a less-than-daily basis."

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