Convention wisdom is that winners accept their good fortune without undue introspection, whereas losers disproportionately ponder their failures.  It follows that the additional time spent by losers contemplating the reasons for their failure should lead to improvements in their behavior.  But new research suggests this is not case; losers merely over- or under-react to new information, reinforcing or possibly exaggerating their suboptimal behavior.

Thinking about investing can be a difficult, stressful, and often challenging process for both investors and for advisors. Understanding the way we think about investing, the processes we use and the principles in play, can help everyone make better choices and ultimately avoid some common missteps of investing.

Some of those missteps can happen when advisors and investors are unable to interpret market conditions fairly or accurately. Former Fed chairman Alan Greenspan, in his recent appearance before a Congressional committee, made note of his mistakes in taking certain things for granted, namely that banks and other financial institutions act in such a way as to “[protect] their own shareholders and their equity in the firms.”  Instead, managers act in their own self-interest, even when it can be at the expense of their shareholders.

Two researchers from Penn State’s Smeal College of Business, Jeremy Ko and Oliver Hansch, explored why people make the choices they do. The idea that reasonable behavior is compromised when people interpret information in the way that best serves their interests is called “motivated reasoning,” and was originally described by Ziva Kunda in her work “The Case for Motivated Reasoning” (1990). Ko and Hansch apply this theory to investments in their paper “Persistence of Beliefs in an Investment Experiment.”

The authors studied a group of 90 undergraduate and MBA students at Penn State University who were given the equivalent of $10 and asked to allocate it over three different choices each week. The first choice, the stock bet, asked the students which of two similarly valued stocks would go up or down, for a double-or-nothing return. The students also had the option of a chance bet, where there was a guaranteed 50% chance of winning. Finally, the students could choose to take the $10 in cash. The study took place over two semesters and students received their winnings in cash at the end of each week.

The participants were asked if they had observed any information about their stock bet over the past week every time they placed a bet. If they had, they were asked to rate it as positive, negative, or neutral. By measuring how many people continued with their bet from the previous week versus how many chose to reallocate their $10, Ko & Hansch were able to determine the probability for the average investor to change his thinking. They also saw whether the new information the traders received influenced their decision whether to change their bet or not.

Participants split their investments as follows: 45% in the stock bet, 20% in the chance bet, and 35% in cash. The researchers assumed participants would stay with a winning stock and change from a losing stock, leading to a 50% persistence in the stock bet. Interestingly, 67% of participants chose not to alter their allocation week-to-week. This means that 17% of the time, the participants acted irrationally, choosing to stick with a stock that did not gain over the previous week, regardless of any indication that the stock might turn around.

Motivated reasoning, as applied to investing, says that investors tend to persist in their beliefs, despite new information to the contrary, and when investors see new information, they react to it differently depending on how it fits with their prior experience. 

Imagine students receiving grades after an exam. Those who had expectations, either of a good grade or a bad one, are unsurprised and unfazed when they receive their corresponding mark. Those whose expectations do not match up with their results, however, are much more wary of their grade. Either something went horribly wrong or they must have been smarter than they thought they were. The ones who do poorly have a greater tendency to question their results; the ones who do well are much more likely to believe that they are simply intelligent.

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