GREAT BARRINGTON >> In the late 1990s, then-Federal Reserve Chairman Alan Greenspan famously used the term "irrational exuberance" to describe the dot-com bubble. Investors crowded into dot-com stocks just as prices rose to nonsensically high prices. Those investors did not tend to fare well.
There is a frustrating tendency among investors to sell stocks after a big drop in price or to buy just after prices have risen — the opposite of what they should do. The problem is that we're not wired for investing.
Economists often assume that human risk preferences are constant. My investments reflect my risk tolerance, but that assumes that my risk tolerance will not change. If I'm risk averse — maybe because I'm approaching retirement or just afraid of losing money — I tilt toward safer investments such as bonds. If I'm risk-seeking — either because I need higher returns or because I have a long time horizon — I tilt toward risky investments such as stocks.
This notion of constant risk preference suggests that we can find the right balance of investments for any individual. It suggests that we can find a balance that compels investors to act rationally. It suggests that we can find a balance that maximizes returns while reducing the urge to trade during volatile times.
This notion is under scrutiny. Recent research suggests that "irrational" investing behavior may be explained by science. It turns out that cortisol levels increase as humans endure greater stress and anxiety — the kinds of emotions our ancestors felt as they were confronted by wolves.
New research finds that as cortisol levels increase, financial risk preferences also change. From the authors of the article "Cortisol Shifts Financial Risk Preferences":
" risk preferences are highly dynamic. Specifically, the stress response calibrates risk taking to our circumstances, reducing it in times of prolonged uncertainty, such as a financial crisis."
Today, we face a different kind of stress and anxiety than our ancestors. We are confronted with spikes in cortisol as markets get choppy and our investments lose value. It is agonizing to think about losing money. We've all felt that pain — it is a physical reaction to financial turbulence. Our bodies are telling us to run away as fast as we can, as if we're being attacked by wolves.
This human reaction was perfectly rational when we had to face a pack of wild animals. Today, we find that it can be detrimental when dealing with financial bears and bulls. It is important to understand this human behavior. Practically speaking, I think there are two primary ways to reduce bad decisions that result from this physical human reaction to volatile markets.
First, investors should acknowledge these tendencies. We must constantly train ourselves — our brains and bodies — to suffer through it. This requires reassurance that we're doing the right thing, even when it feels wrong. I find that the best way to do this is to regularly read financial literature that appreciates these nuances of human behavior and investing (Barry Ritholtz, Josh Brown, Jason Zweig, and Carl Richards are good authors to start with). Some people choose to lean on financial advisors or planners when their bodies are telling them to run away.
Second, we should appreciate this natural tendency and choose to take less risk, settling at a level below where we "think" we're comfortable. If you think you're comfortable with 80 percent of your money in stocks, maybe try 60 percent instead, understanding that your body may not be able to handle the stress of 80 percent in stocks.
It is critical that we understand ourselves and our impulses before we can make wise financial decisions.