Money

With the weather unseasonably warm last month, I was often out walking the dog after dinner. One evening it was particularly nice outside. As we passed bicyclists, runners, and other walkers, Charlie, my twelve-pound Cavalier King Charles spaniel, took little notice. He was content to enjoy weather that felt more like April than January. Only when we approached a man walking a large German shepherd did wee little Charlie become alarmed, growling and lurching at a dog four times his size. I tightened my grip, and the shepherd’s owner did the same. As we strangled our dogs past one another, we each managed a courteous nod.

I wondered for the rest of the walk whether Charlie would be so courageous had I not restrained him, and let him go ahead and become an appetizer for that dog. Would that temper his enthusiasm for such brash behavior? Would it result in less eventful walks in the future?

Last week, I had a conversation with a friend who was desperate to get shares of a red-hot and fairly risky I.P.O. I couldn’t help but recall how this same friend, confiding in me a year earlier, had wanted to cash in his blue-chip portfolio and stick it all in risk-free government bonds. The risks of investing, he said at the time, were imminent. Osama, bird flu, Hillary Clinton; too much impending menace to stay in the market, he opined.

Thinking back, I remembered how past money-talks with this friend had jumped from paralyzing fear to unmitigated risk-taking, so his jumpiness wasn’t completely surprising. He panicked in 1987 when his stocks sunk, freaked out when interest rates rose in 1990 and 1994, and wanted to pour his portfolio into technology stocks in 2000. In other words, he had often exhibited courage when the weight of the world gave him its thumbs-up. But he became fearful after experiencing financial pain. Most investors are like my friend. They are hardwired to make the same mistakes time and time again.

There is a sub-discipline within the study of economics called “behavioral finance.” It suggests that financial markets are neither rational nor random for the simple reason that its participants tend to be neither of these things. Most investors make pattern mistakes in the same way my dog is inclined to overestimate his bite, but then cowers for a few days every time he takes a beating. Much in this way, investors get excited when the market goes up, depressed when the market drops, and they have no long-term memory.

The reality of financial markets yesterday, today, and tomorrow is this: Stocks go up when excited people buy, down when scared people sell. Sometimes we become over-stimulated by the world around us, much like Charlie does, and we end up biting off more than we can chew. We lurch at perceived opportunity. We retreat while licking our wounds. This brand of knee-jerk logic, motivated by the never-ending cycle of fear and greed, is subscribed to, in varying degrees, by every investor. It doesn’t add up in the real world. But it makes perfect sense to my dog.—Howard Punch with John Carraux