Economists have long been baffled by what they call the equity-premium puzzle: Long term, on average, stocks outperform bonds by a decent margin, yet people tend to put more money into bonds than they do into stocks. Why?
Economists and neuroscientists at Carnegie Mellon University and the University of Iowa decided to find out whether people's feelings got in the way of their intellects. They found that stroke victims and others with damage to the emotional centers of their brains made better investment decisions than those with a full range of emotions.
The researchers gave the subjects $20 and asked them to invest—that is, bet on the flip of a coin, a dollar at a time. Heads, they lost $1; tails, they ended up with $2.50. On any flip, they could decline to invest and simply keep the dollar. Given the fifty-fifty odds of a coin toss, a subject would on average pocket $25 by gambling every time but end up with only $20 for consistently keeping the money. Healthy subjects tended to hold on to their dollars, investing only 58 percent of the time. Subjects with brain damage bet on 84 percent of the flips and made more money.
The healthy subjects may have felt safer with the money in hand, a feeling that overruled their logical thinking, says George Loewenstein, a lead scientist on the study. "In the stock market you get compensated for taking risks," he says. "But there are other situations where it can be disastrous. People can end up losing their job and losing their family."
"Do Emotions Cloud Common Sense?" "Investment Behavior and the Negative Side of Emotion." Baba Shiv et al. in Psychological Science, Vol. 16, No. 6, page 435; June 2005. http://www.blackwellpublishing.com/journal.asp?ref=0956-7976.
