That's Not the Way I Remember It
Memory is not a factual recording of events. Psychologists have determined that memory is instead a perception of a physical and emotional experience. This perception is affected by the way in which the events unfold. The process that records events in the brain can store different features of the experience. These stored features are the basis for subsequent recall.
Memory has an adaptive function: It determines whether a situation experienced in the past should now be desired or avoided. For example, if you remember an experience as having been worse than it really was, you would be excessively motivated to avoid similar experiences. Alternatively, if you remember an experience as better than it was, you will invest too much effort in seeking similar experiences. Therefore, inaccurate perceptions of past experiences can cause you to make poor decisions.
Experiments in psychology illustrate how memory works to affect decision making. Students experienced pain by sticking their right hands in ice water (temperature of 57°F) for 60 seconds.1 Each student placed the left hand into the water for 90 seconds. However, in this trial, after the first 60 seconds at 57°F, the water temperature was increased to 59°F (unbeknownst to the subjects) for the final 30 seconds. Note that the left hand experienced the same level and duration of pain as the right hand. Then the left hand experienced a 50% lower duration of pain, but pain at a lower level. Which hand experienced more pain? Which experiment (short duration or long duration) would you endure if given the choice?
Seven minutes after dipping the second hand in the ice water, the students were given a choice of which experiment they wanted to repeat. Nearly 70% of the students chose to repeat the long trial! Why did they choose the pain experiment with the longer duration?
The duration of experiences has little or no independent effect on the perception, or memory, of the pain experience. The most important factors of the pain experience are the peak pain level and the pain level at the end of the experience. The memory of the pain seems to be the average of the peak pain level and the final pain level (theory of remembered utility).1
For the short trial with the students, the peak pain level and the pain level at the end of the experiment were the same. However, because the long trial increased the temperature (decreased the pain) at the end, the end pain level was lower than the peak. Therefore, the average between the two levels was lower in the long trial than in the short trial. Consequently, students remembered the longer trial as less painful even though it started with the exact same level and duration of pain as the short trial but then added 50% more duration at a lower pain level.
In this experiment, a majority of the students chose to repeat a more painful experience because their memory failed to recall an accurate perception of the past experience. In a similar experiment, researchers found that students' memory of the experience changed over time—the farther in the past the pain trials, the less painful the students remembered them to be.3
MEMORY AND INVESTMENT DECISIONS
The phenomenon of our perception of past experiences being different from the facts of the experience can affect investors as well. The price pattern of a stock can affect how you make decisions in the future. Say you purchased stock in two companies—a biotechnology corporation and a pharmaceutical company—and that each stock is $100 a share. Throughout the following year, the price of the biotechnology stock slowly declines to $75. The price of the pharmaceutical stock stays at $100 until the very end of the year, when it plunges to $80.
For the year, the biotechnology stock was a worse underper-former than the pharmaceutical stock, but the way in which each
stock lost money was quite
pharmaceutical stock experienced a dramatic loss at the end of the year. Even though the biotechnology stock was the poorer performer, the slow loss is less painful for you. Therefore, when making decisions about these stocks for the following year, you may mistakenly be more pessimistic about the better performer than you are about the poorer performer.
This same pattern occurs for pleasurable experiences as well. You feel better about experiences with a high pleasure peak and end. Let's look at a different scenario in which the two stocks had an increase in price instead of a decrease. The biotechnology stock slowly increased to $125 over the year. The pharmaceutical stock rose dramatically to $120 at the end of the year. Your memory of these events causes you to feel better about the pharmaceutical stock even though it did not perform as well.
COGNITIVE DISSONANCE
Psychologists have studied specific consequences of memory problems. Consider that people view themselves as smart and nice. Evidence that contradicts a person's image of being smart and nice causes two seemingly opposite ideas. The brain is uncomfortable with the poor self-image. Psychologists call this feeling cognitive dissonance. To avoid this psychological pain, people tend to ignore, reject, or minimize any information that conflicts with their positive self-image. Evidence that cannot be denied is accommodated by a change in beliefs.
Your beliefs can change to be consistent with your past decisions. You want to feel like you made the right decision. For example, racetrack gamblers were surveyed about the odds of their horse winning. Bettors just leaving the betting window gave the horses they bet on a better chance of winning than bettors standing in line to place their bets.4 Before placing the bet, you feel more uncertainty about your chances. After placing the bet, your beliefs change to be consistent with your decision.
The avoidance of cognitive dissonance can affect the decisionmaking process in two ways. First, you can fail to make important decisions because it is too uncomfortable to contemplate the situation. For example, when considering the thought of saving for future retirement, some younger people may conjure an image of a feeble person with low earning power. To avoid the conflict between the good self-image and the contradictory future self-image, they avoid saving entirely. Second, the filtering of new information limits your ability to evaluate and monitor your investment decisions. If you ignore negative information, how are you going to realize that an adjustment to your portfolio is necessary?
Cognitive Dissonance and Investing
Most people seek to reduce psychological pain by adjusting their beliefs about the success of past investment choices. For example, you make a decision to purchase a mutual fund. Over time, performance information about the fund will either validate or put into question the wisdom of picking that fund. To reduce cognitive dissonance, your brain will filter out or reduce the negative information and fixate on the positive information. Therefore, your memory of past performance will be better than actual past performance.
Researchers asked two groups of two questions about the previous year's return on their mutual fund investments to see how close investorrecollection came to actual performance.
1. What was your return last year?
2. By how much did you beat the market?5
Note that these questions ask about both actual performance and performance relative to the possible alternatives.
What was your return last year? Most people don't remember their exact return. However, if they are not affected by cognitive dissonance, then some will remember the return as lower than the actual return, whereas others will remember it as higher. In a group of investors, the recollections of performance should average out to be near the actual performance.
As I mentioned before, researchers asked two groups of investors these questions. The first group consisted of architects. Architects are highly educated professionals, but they may not be knowledgeable about investing. Twelve architects responded regarding 29 investments they owned through their defined contribution pension plan. Figure 10.1 shows the errors in the architects' memories. On average, they recalled investment performance that was 6.22% higher than their actual return. They thought they did much better than they actually did!
It is very difficult to outperform the market. Most stock mutual funds cannot consistently beat the S&P 500 index. So, by how much
did the architects think they beat the market (the researcher's second question)? On average, their estimate was 4.62% too optimistic. This group of investors overestimated their actual return and overestimated their return relative to a benchmark.
Vou want to believe that your investment decisions are good. In the face of evidence to the contrary, the brain's defense mechanisms filter out contradictory information and alter the recollection of the investment's performance. |
The second group of investors in this research study were members of a state chapter of the American Association of Individual Investors (AAII). The AAII is an association that provides education, information, and services to individual investors, so presumably its members are well educated in investing. Do these investors overestimate their past returns?
Twenty-nine AAII members responded concerning 57 mutual funds they owned. These investors overestimated their past return by 3.40% on average. They overestimated their performance relative to the market by 5.11%. Even though these people are educated investors, they are overly optimistic in recalling their past returns.
four equity funds.6 It is known as the Rodney Dangerfield of mutual funds. Consider this from Barron's:
That is the crux of one [of] the great financial mysteries of our time: Who owns the Steadman funds, the family of investment vehicles whose performance, by nearly every measure, over virtually any period imaginable, is easily the worst on the planet, throughout the universe, in any dimension?7
A little over the top? Not considering that the Steadman funds rank near or at the bottom of all mutual funds over the past 15-, 10-, and 5-year periods. In the mid-1990s, during one of the strongest bull markets ever, the Steadman funds had actually lost money. Although some of this terrible performance can be attributed to poor stock selection and heavy portfolio turnover, most of it is caused by the fee structure. The annual expenses have ranged from 15% to 25% of assets under management. The average mutual fund expense is 1.4%. With expenses like that, who could expect to earn money?
These facts have been published frequently in the media. In addition, a lawsuit and trouble with the SEC have also made headlines. After receiving all this information, who would still own mutual funds like these? Due to the filtering of the brain to reduce cognitive dissonance, the information may not have gotten through to thousands of shareholders. When asked, shareholders admit to ignoring the fund for long periods of time. Some things are just too painful.