Blogs | December 18, 2013

My top five lessons for 2013

2013 has made us a year older. But are we a year wiser? If you pay attention to proper economics, you should be – because economic researchers have this year discovered some things that should help us with our saving and investment decisions.

Here are some of my personal favourite pieces of this year’s economic research.

1. Emotions affect risk-taking
First, we have evidence that emotions are dangerous for our finances. Some evidence for this comes from experiments by Claudia Nardi of the University of Verona and colleagues. They showed people film clips intended to make them angry, fearful or happy and then got them to choose between various types of lotteries. They found that most emotions caused people to take more risk than they did in neutral states – something which was more true for men than women.
This is dangerous because risk-taking isn’t always good for us. In separate work, Charles Noussair and Adriana Breaban used facial recognition software to track people’s emotions whilst they traded in an experimental market. They found that the traders who made the highest profits were those who remained least emotional as prices gyrated.

2. Follow the herd and take more risk
But it’s not just emotions that can lead us to make poor investment choices. So too can other people. Matteo Ploner at the University of Trento ran an experiment in which subjects were asked to choose between safe investments and riskier ones. He found that when people were told of others’ choices, their own decisions resembled others’ more closely than they did when they were not informed what others had done. In particular, people who had made cautious choices made riskier ones when they learned that others were more adventurous than them. “Social effects play a fundamental role in investment choices” he concludes.
Real-world research corroborates this. In a study of Norwegian investors, Hans Hvide of the University of Aberdeen discovered that people who work together tend to own similar shares – suggesting that our investments are influenced by peer effects. This would be no bad thing if we learned about good investments from others. But in fact, found Mr Hvide, stocks bought under peer pressure did no better than average.

3. Thinking of others helps reduce over-trading
There’s another thing that causes us to invest badly – the tendency to trade too much. Now, it’s been known for years that over-trading is bad for us. A new paper by David Navon at the University of Haifa shows one reason why. It’s because of what he calls egocentric framing. To see this, imagine I give you and a stranger an envelope each. I tell you both that one envelope has twice as much money as the other, and ask you if you’d like to pay me a small fee to swap. You might well think it a good idea to do so, because a 50-50 chance of doubling your money or halving it has a positive expected return. But the stranger thinks the same. I can therefore take money from both of you by getting you to swap, even though the swaps can’t make you both better off.
The error you make here is to think egocentrically – to ask only “what’s in it for me?” without asking about the other side of the trade. If you ask before buying a share “why does the holder want to sell to me?” you’d trade less often and lose less.

4. Take a tip from Warren Buffett
These findings help explain why stock-pickers go wrong. But how can they get it right? One way is to learn from the most successful investor of our age, Warren Buffett. Lasse Pedersen and colleagues at AQR Capital Management show investors how to do this. They show that one secret of Mr Buffett’s success has been not that he’s a brilliant stock-picker but rather that he’s had the discipline to stick with the strategy of holding defensive, quality stocks even in times when they did badly, such as during the tech bubble. He’s therefore been able to profit enormously when good long-term principles come back into favour. Investors who are swayed by emotions and fashion have not had his discipline.

5. Question rules of thumb
This tells us that it’s important for investors to follow rules. But some rules – popular as they are – are wrong. Javier Estrada at IESE Business School in Barcelona shows that this is the case for the traditional advice to own fewer shares and more cash or bonds as you get older. He calculates that, for most countries, this advice leads to lower retirement wealth than the opposite strategy, of investing more in equities as you age.

There’s a common theme here. It’s very easy to make investment errors, because we get lead astray by trading too much, or by peer pressure or by our emotions. Maybe economics can’t make you rich. But in reminding us of mistakes to avoid, it can at least stop us losing money.

Chris Dillow
Chris Dillow

Investors Chronicle writer and economist