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Who's in the Video
Michael Mauboussin is the chief investment strategist at Legg Mason Capital Management. Before joining LMCM in 2004, he was a managing director and chief U.S. investment strategist at Credit Suisse.[…]

The best investors tend to be more reserved, more independent, and less attuned to what other people are doing.

Question: Has the financial crisis made us more risk-averse? 

Michaelrn Mauboussin: The first important thing to articulate is that when wern enjoy a gain of a dollar and the loss of a dollar which are, of course,rn symmetrical, we tend to suffer two to two and a half times more from rnthe loss then we enjoy the gain, so there’s this asymmetry of suffering rnversus joy in financial matters that’s important to lay out. The key, rnthough, that loss aversion ratio; there are two key points about it. rnNumber one is its different from person to person. So you and I may rndiffer in our loss aversion coefficients and that really is true across rnthe population and the second is: your own loss aversion coefficient mayrn change based on your most recent experience. So if you’ve been winning arn lot lately, you may have one risk attitude; and if you’ve been losing arn lot, a different risk attitude. 

There’s one study I can’t rnresist telling you about which is really fascinating in this regard. Andrn what they did is they took people that were unfortunately brain rndamaged—this is mostly from stroke victims—and the key to that brain rndamage is that it did not affect their mathematical or calculation rncapabilities, so they could do math fine, they understood present rnvalues. The part of their brain that was damaged was their emotional rnseat, their ability to feel fear or greed or anguish or those kinds of rnthings. And then they pitted that group against a group of normal peoplern and here is the contest. They were given $20, and they were to play 20 rnrounds of a game and in each round, you could do one of two things. Yourn could just keep the dollar, put it in your pocket, go on to the next rnround. Or you could hand your dollar over to the researcher who would rnflip a coin and you would get $2.50 for the correct call and you would rnlose your dollar if you had an incorrect call. 

If you work out rnthe math of this, it’s not very complicated. You should hand your dollarrn over because its $1.25 expected value versus just keeping your dollar. rnAnd incidentally it was really cool. First five rounds pretty much rneverybody gets it, so everybody's handing their dollars over, right? Butrn to make a long story short, at the end of the game, what they found wasrn the brain-damaged people ended up with 13 percent more money than the rnnormal people, which is a very large margin given only 20 rounds of the rngame and, in particular, it's because they played many more rounds than rndid the normal people and, specifically, twice as many rounds after rnhaving suffered a loss. 

All right, so you can imagine you’re rnplaying this game, you’re one of the normal people, you hand your dollarrn over, you win some, you lose some. But if you lose a couple in a row, rnyou can see the thought of, you know, maybe I’ll just keep my dollar in rnmy pocket here, sit out a couple of rounds and then I’ll come back when rnI’m feeling better. And you can see how that ports right over to the rnstock market. When you’re doing well, you want to keep handing your rndollars over because you’re feeling really good about things, but if rnyou’ve lost for some time, you might say to yourself, you know what, I’mrn perfectly happy to put this dollar in my pocket and sort of sit out a rnround or two. 

So how is this manifesting? Well, the S&P 500,rn the widest known benchmark for the market, has been down for the last rnten years. Anybody that invested for the last ten years has lost money. rnThat doesn’t feel good. So what people do is they either put it in cash rnand or cash balances are really high in America, or they buy bonds, rnright, fixed income, a little bit more boring, less racy, but it's rnequivalent to having the dollar in your pocket. 

Now what allows rnus to turn around? I’m not really quite sure. If the markets do do rnbetter, people will slowly tiptoe back into the market. We had a much rnbetter 2009 and we’re starting to see that flow now back into equity rnfunds and much less into bond funds. 

One interesting question rnis: are people scarred by this? Will a generation be scarred? And the rnanswer may be yes. However, if you go back into history in the 1920s andrn 1930s where we obviously had a very difficult market, following that rnreally difficult period, the markets did improve, so somebody was buyingrn the stocks back in that period as well. So my own sense is if the rnconditions are right—valuation, economic growth and so forth—the rnconditions are right for markets to do better, we will indeed see betterrn returns and that risk aversion will fade a little bit into the future. 

Question:rn Do emotional people have less success as investors? 

Michaelrn Mauboussin: I will say I think you’re on to a really important rnthread, which is the bottom line is that people that are very outgoing rnand people oriented and attuned to other people’s emotions tend to have arn difficult time investing because they feel most comfortable as being rnpart of the group. People that tend to be more reserved, more rnindependent, less attuned to people emotionally, tend to be better rninvestors. So it’s not a judgment call because some of these—I don’t rnknow if you want to call them skills—but these natural tendencies may rnnot serve you well in other facets of your life.
Recorded on May 14, 2010
Interviewed by Jessica Liebman