Zweig, Jason. Your Money and Your Braine

than 94,000 estimates of quarterly earnings over roughly twenty years and found that they resulted in negative surprises more than 29,000 times. More than 1,250 times in 2005 alone, companies announced quarterly earnings that fell one penny per share short of what Wall Street expected. According to Numeric Investors L.P. of Cambridge, Massachusetts, the shares of these companies immediately fell by an average of 2%.

Often, the results would be funny if they weren't so scary: In January 2006, when Juniper Networks Inc. announced quarterly earnings per share that were just one-tenth of a penny less than analysts expected —along with a slight slowdown in projected future growth—the market value of the stock almost instantly fell 21%, or $2.5 billion.

The least surprising aspect of earnings is that they are full of surprises; the most surprising aspect is that investors are continually taken by surprise. Why don't we learn more from experience? What makes negative earnings surprises so common? How come a $65 million booboo can set off a $20 billion bloodbath? The best way to answer these questions is to drill down into the brain and see what's going on in there.

The Belt of the Unexpected

In a typical day, you say something like "That's amazing!" or "Wow!" or "You've got to be kidding" over and over again. Our superabundant sense of surprise appears to be one of the main features that set humans apart from other animals. Where does it come from?

Humans and great apes—chimpanzees, gorillas, and orangutans—are the only land mammals that have specialized neurons called spindle cells in a central forward region of the brain known as the anterior cingulate cortex, or ACC. Humans have at least twice as many spindle cells in this region as the great apes do. The spindle cells, which resemble partially unwound corkscrews, may latch on to signals from other areas of the brain, helping the ACC to focus attention, perceive pain, and detect errors. The ACC also assists in generating the feeling of surprise when your normal expectations are shattered. (Some neuroscientists call it the "Oops!" center or the "Oh, s--t!" circuit.) Cingulate is from the Latin for "belt," and this part of the cortex lies directly above a strip of tissue that stretches like a band along the top of the limbic system. There's no doubt that other regions of the brain are also sensitive to surprise, but the ACC has been studied the most thoroughly so far.

The ACC must have given our ancestors an evolutionary edge. Because their ability to walk upright enabled them to range over a wider territory, the early hominids encountered a greater variety of both risks and rewards than other primates did. "This rudimentary system in monkeys probably expanded in humans to signal more general errors and violations of expectancy," says Harvard neuroscientist George Bush. "It's more important to know about mistakes sooner than it is to know about successes." The farther our ancestors ranged from "home," the more vital it became to make this kind of decision quickly and accurately. For these restless protohumans, the familiar was more often mixed with the unfamiliar; to give one possible example, a variety of berry that looked only slightly different from the usual kind might well be poisonous. The hominids that reacted with the greatest surprise to the least differences were the most likely to survive.

"These cells process the rapid integration of very large volumes of information across time and space on a second-by-second basis," says John Allman, a neuroscientist at the California Institute of Technology. "It's an intuitive system that's built for speed. In a state of nature, there's no luxury of working through all the logical steps to arrive at the ideal 'rational' solution. Where uncertainty is maximal, the importance of learning is maximal and attention is highly focused." Neurons in the ACC respond to a variety of surprising or conflicting events in less than three-tenths of a second.

The ACC receives input both from dopamine neurons that carry reward signals and from neurons originating in the amygdala that fire in response to risk. It also is closely connected to the thalamus, at the center of the brain, which helps direct attention to the input from your senses (like sights or sounds or

smells). And the ACC is linked to the hypothalamus, another part of the reflexive brain that acts much like a thermostat, regulating your pulse, blood pressure, body temperature, and blood chemistry to keep them all close to the proper setting. When a surprise jolts your ACC, it can hit your hypothalamus in turn, knocking your internal thermostat out of kilter. No wonder a one-penny shortfall can put Wall Street into a multibillion-dollar panic.

You can sense your own ACC at work in a simple experiment called the Stroop test. Devised in 1935 by a psychologist with a name out of a Marx Brothers movie, J. Ridley Stroop, this task asks you to name the color in which various words are printed. (It's harder than it sounds. You can try a basic version at www.jasonweig.com/stroop.ppt.) The first change will almost certainly catch you by surprise; even if you do get it right, you will probably feel yourself doing a double-take that slows you down. After a few stumbles, it will get easier. Neuroscientist Jonathan Cohen of Princeton University has shown that the more active your ACC is when you flub one step in the Stroop test, the faster you will succeed at the next one. By alerting you that something has gone wrong this time, the ACC enables you to adjust your behavior to get it right next time. Once burned, twice shy.

The Asymmetry of Surprise

Even in monkeys, the cingulate flares up when a choice leads to a lower reward than expected (for instance, getting less fruit juice). Among humans, money—that modern product of advanced civilization —triggers a peculiarly primitive response when surprise is involved. In one experiment, people had to identify the odd letter in a string as fast as possible (for example, the S in HHHSHHH). Each time they made a mistake, they could gain money, lose money, or suffer no financial consequence. When errors resulted in a monetary loss, the ACC fired much more intensely than it did when no money was at stake. And a wide swath of cells in the brainstem (a region atop the spinal cord that regulates basic bodily functions) also switched on whenever a mistake cost money. When an identical error did not produce a financial penalty, however, the brainstem barely responded at all. (See Figure 8.1.) That's especially striking because the brainstem is one of the most ancient parts of the human mind.

"People make mistakes all the time," says University of Michigan psychologist William Gehring, who helped run this study. "But the ones we really care about, and the ones we try hardest to avoid in the future, are the ones that have an important negative consequence"—like losing money.

Using tiny electrodes, researchers measured the activity of single neurons in the ACC while people tried to move a joystick in the right direction to earn a variable cash reward. It turns out that 38% of the neurons fired when the amount of money suddenly shrank, but only 13% were triggered when people got a larger than expected gain. And those neurons that did respond to a positive surprise sent out weaker signals. With these insights, we can finally understand why stocks that beat Wall Street's expectations go up an average of 1%, while those that come up short lose an average of 3.4%. At the most basic biological level, a positive surprise packs a lot less punch than a negative one.

Why Apple Got Bruised

The intensity of your surprise depends largely on how unexpected the surprise is. The longer a sequence has repeated, the more vehemently your ACC will respond when the pattern is broken. Batches of neurons throughout your reflexive brain will join in, especially in the insula, the caudate, and the putamen —areas that help generate intense emotions, including disgust, fear, and anxiety. Scott Huettel, a neuroeconomist at Duke University, has shown that the ACC reacts roughly three times more vigorously if a pattern reverses after eight repetitions than it does after a three-in-a-row pattern is broken.

The stock market provides uncanny real-world proof of Huettel's laboratory findings: The more times in a row a company has exceeded Wall Street's expectations, the worse its stock gets whacked when it finally misses the analysts' forecasts. While a shortfall after a run of three good earnings reports trims just 3.4% off the price of the typical growth stock, a miss after a streak of eight positive quarters hacks off 7.9%.

So there's a lot more at stake after a string of successes. When expectations are especially high, a miss hurts even worse; that's why a market superstar like Google gets hit extra hard after any shortfall. And "growth" stocks, with the accelerating profits that most investors prize, are more vulnerable to a negative surprise than slower-moving "value" stocks are. When firms warn in advance that they will be unable to meet Wall Street's lofty expectations, their shares lose an average of 14.7% in two days.

The more closely all the analysts agree on what a company's earnings will be, the worse the stock will get walloped if the actual numbers fall short. In addition, the higher the overall market rises, the harder any single stock will get hammered when it stands out with a negative earnings surprise. And Wall Street's analysts are twice as likely to downgrade a company after an unexpected decline in its stock price as they are after a surprise increase—even though a short-term fall in price makes a stock more attractive as a long-term value. There's nothing like a negative surprise to deepen Wall Street's chronic confusion between price and value.

How big and bad can a surprise be? On September 28, 2000, Apple Computer Inc. announced that its quarterly earnings would be about $55 million less than it had previously estimated. At about 27% better than the same period a year earlier, it was hardly a poor result. But Wall Street's analysts were expecting Apple to do even better. The next trading day, Apple stock fell by 52%, vaporizing $5 billion of the company's total market value. For each million dollars of Apple's shortfall in earnings, Wall Street slashed the market capitalization of the stock by more than $90 million.

Now that Apple's shares were available at more than 50% off, did analysts raise their ratings? Certainly not: Instead, they scurried to downgrade it, warning investors to stay away now that a "cloud" hung over the stock. But Apple's problems were only temporary; in no time, the iMac and iPod were powering the company to record profits. Investors who got scared out of Apple by that one negative surprise were in for a much nastier surprise: Over the next six years, the stock sextupled. Even people who bought Apple just before its "earnings warning" could have more than doubled their money if they had hung on instead of selling.

The Bad News Bears

Of course, the corporate world is well aware that investors hate negative surprises. In the 1990s, CEOs and other senior executives fixated on "making the numbers"—that is, ensuring that they would meet Wall Street's earnings expectations to the penny. In a survey at more than four hundred leading U.S. companies, fully 78% of senior financial managers said they would be willing to hurt the long-term value of their businesses in order to prevent a short-term dip in earnings. One chief financial officer admitted that the company would delay routine maintenance to meet quarterly earnings expectations, even if putting off this vital upkeep would cost far more money down the road. Another executive revealed that when his company earned a $400 million profit by selling off one of its businesses, he used a complex financing technique to spread the gain in equal $40 million increments over the next ten financial quarters. While this gimmick created the illusion of "smoother" earnings in the future, it incurred very real (and unnecessary) investment banking fees in the present.

Companies that consistently give "earnings guidance" to Wall Street—by setting a target that they attempt to hit to the penny—end up spending much less on research and development. Their fear of giving Wall Street a current surprise hurts the future profitability of these companies, since today's research and development budget can be a leading source of tomorrow's growth. Companies that cannot bear the pain of a surprise in the present become afraid of investing in their own future.

Over time, thousands more companies beat earnings forecasts by one or two pennies than fall short by the same amount—a difference far too great to be a coincidence. As Harvard economist Richard Zeckhauser explains, when earnings are in danger of "falling just short of thresholds," they are "managed upward" by company insiders. But these short-run fixes fall apart in the long run. Firms that barely meet their earnings targets—implying that they had to pull out all the stops to get there—end up with lower earnings growth (and stock performance) than companies that either beat their targets by a wide margin or fall short.

A few years ago, Joseph Nacchio, the CEO of Qwest Communications International Inc., was obsessed with hitting Wall Street's earnings targets. "The most important thing we do is meet our numbers," Nacchio declared at a companywide meeting in January 2001. "It's more important than any individual product, it's more important than any individual philosophy…. We stop everything else when we don't make the numbers." And if Qwest couldn't make the numbers, it could make up the numbers. To avoid the terrible penalty that Wall Street deals out for negative surprises, Qwest relied on accounting gimmicks, delaying current expenses into the future and moving revenues from the future into the present. Employees were ordered so often to use these tricks that they nicknamed them "heroin." But Qwest overdosed: The stock fell 65% in 2001 and another 65% in 2002 as the company was forced to erase more than $2.5 billion in phantom earnings. Desperate to avoid even the tiniest surprise, Qwest ended up creating a monster.

Breaking the Cycle of Surprise

After writing about Wall Street since 1987 and studying centuries' worth of financial history, I have become convinced that the prevailing view of what the future holds is almost always wrong. In fact, the only incontrovertible evidence that the past offers about the financial markets is that they will surprise us in the future. The corollary to this historical law is that the future will most brutally surprise those who are the most certain they understand it. Sooner or later, sometimes slowly and sometimes suddenly—but with a diabolical ability to root out everyone who has ever gazed into a crystal ball—the financial markets always humiliate whoever thinks he knows what's coming. So the best way to immunize yourself against being surprised is to expect to be surprised. In an axiom proposed by Edgar Allan Poe and perfected by G. K. Chesterton, "wisdom should reckon on the unforeseen." Here are some specific steps you can take to embrace the unexpected.

EVERYBODY KNOWS NOTHING. Investors often justify their decisions by saying, "Everybody knows that…" In 1999, for example, everybody knew that the Internet would change the world. In 2006, everybody knew that energy prices would keep going up. But whatever "everybody knows" is already embedded in the price of a stock or the expectation of an entire market. If what "everybody knows" does come perfectly true, the price won't change. If it comes only partly true, however, then the price will collapse. Unless you can come up with insights of your own that have nothing to do with what "everybody knows," you don't know anything that the market hasn't already built into the price. Whenever you are tempted to do what everybody else is doing, don't. Instead, try to find a less obvious investment opportunity that most people have somehow overlooked.

HIGH HOPES CAUSE BIG TROUBLE. As money manager David Dreman has pointed out, expectations are usually so high for glamorous growth stocks that a positive surprise will barely make a ripple, while even the smallest negative surprise can capsize them. On average, a growth company that misses earnings by as little as three cents per share will see its stock drop two to three times farther than a value company with a similar shortfall. Conversely, expectations are so low for cheap value stocks that a negative surprise won't hurt much; but a positive surprise can send a value stock shooting straight up.

In the short term, value stocks tend to have lumpier, less linear earnings than growth stocks do. As the profits and share prices of value stocks bounce around, our brains probably seek to interpret them as an alternating pattern ("up, down, up, down") rather than the simple repetition that growth stocks often show in the short run ("up, up, up"). Alternation requires extra mental energy to understand. Experiments in neuroeconomics have shown that the brain takes longer to grasp an alternating pattern than a repeating one—about six iterations, as opposed to two.

That may explain why value stocks are so consistently underpriced: Because the path of their earnings growth is more erratic in the short run, your reflective brain has to work harder to predict what's coming next. The simple upward sweep of a growth stock, on the other hand, automatically lights up the emotional circuits in your reflexive brain. A steadily rising price automatically feels more predictable. The longer a company keeps beating Wall Street's expectations, the more "buy" orders outnumber "sell" orders for its stock; buying demand is over five times higher after six straight positive surprises than it is after two

in a row. That helps drive growth stocks up, at least for a while. A string of positive surprises makes investors more confident that a stock is "predictable"—but also jacks up the risk of a horrible loss if the next surprise turns out to be negative.

Because repetition is so much easier for our brains to interpret than alternation, these short-term patterns lead us to overlook the longer-term truth: Over time, value investing is at least as lucrative as a growth-only strategy.

TRACK THE "WHYS" OF SURPRISE. In a classic experiment, psychologists mixed carefully faked cards into a deck of regular playing cards. For example, they added an ace of diamonds printed in black, a six of clubs printed in red. This simple switch triggered several results. First of all, it took the average person four times longer to name the suit and value of the altered cards than the normal ones. Secondly, people were flummoxed: They were sure that something was wrong but unsure what. Shown a red club or a black diamond, people often insisted it was printed in "purple" or "brown." One person sputtered at the sight of a red spade, "I'll be damned if I know now whether it's red or what!" On the other hand, the more times people had previously seen an altered card, the easier it became for them to identify it correctly and quickly.

The obvious lesson is that the more often you see things that surprise you, the less likely you are to be flustered. Keeping careful mental notes—or better yet, written notes in an "emotional registry" or investing diary—will help you learn from your past surprises. Keep track of what surprised you, how you felt, and what you did in response. Pay special attention to describing what had happened earlier to make the surprise so unexpected. Flesh out your explanation by filling in the blank in a sentence like "This outcome took me by surprise because ______________________________________________." Instead of writing a generalization like "I just wasn't expecting it," think of specific factors, like "the stock had doubled since I bought it" or "all the news about the company was positive."

STAY AWAY FROM GUIDED MISSILES. Many companies give "earnings guidance," doing a nudge-nudge-wink-wink with Wall Street's analysts to hint at what the next quarter's earnings will be. If an analyst estimates earnings of $1.43 per share, the company's chief financial officer may say, "We think that's a tad aggressive," leading the analyst to cut his forecast to $1.42. Then, when the company earns $1.43, the analyst and the company alike can boast that it "beat the forecast." Calling such a cynical manipulation a "positive surprise" is just silly. But the negative surprises that inevitably follow are very real, as the messy reality of business life comes barging in out of left field. Interest rates or oil prices suddenly rise or fall; a hurricane or earthquake hits; workers go on strike; a competitor invents a great new product. The result is a guided missile: a stock whose earnings guidance blows up precisely when it can do the worst damage.

For sensible investors, there is only one logical conclusion: You should ignore the entire farce. Increasing numbers of brave companies refuse to give any earnings guidance; among them are Berkshire Hathaway, Citigroup, Coca-Cola, Google, InterActive Corp., Mattel, Progressive Corp., and Sears. Instead of wasting precious energy trying to make their results match their guidance in the short run, these companies have the luxury of focusing on improving their performance over the long run. On average, firms that give less guidance should be more rewarding over time.

LOOK UNDER THE STATISTICAL HOOD. The financial industry teems with people who are experts at twisting numbers to separate investors from their cash. Here are some of their statistical gimmicks, and tips on how you can keep them from taking you by surprise.

Incubation: Mutual fund companies create private portfolios, then track which of them succeed. The failures are terminated in secret, while the successes are trumpeted in advertisements hyping their marketbeating track records. Across different fund categories, this fancy footwork can add between 0.2 and 1.9 percentage points annually to the average reported return—even though no one outside of the fund company ever earned it. "Incubated" funds typically go on to underperform in the long run. To avoid being

surprised by one of these babies, always read the fine print in the prospectus of a new fund. Among the red flags: footnotes under "inception date" indicating that the fund was not available to the public early in its life, total net assets that stayed at or below $1 million in the fund's first year, and total return that was inexplicably high in year one.

Bait and switch: Brokers and fund companies wait until one of their investments—any of their investments—is doing well over some time period, and then advertise that track record. As soon as that investment stops doing well, they hype the results from whatever time period happens to look better. The simplest defense is to look at returns over several periods that begin and end on different dates.

In another bait and switch, fund companies run ads bragging about how many of their portfolios have earned "five stars," the highest rating from the Morningstar research firm. But, as a matter of policy, Morningstar awards five stars to 10% of all funds. If a company boasts that three of its funds have five-star ratings, but it offers a total of 60 different portfolios, that's not something to brag about; it's something to be embarrassed about. The company has only half as many top-rated funds as the average firm. There's an easy way to keep from being surprised by this kind of statistical shell game: Whenever someone throws a number at you, always remember to ask, "Compared to what?"

Burying the dead: Often, the track records of losing investments are erased from history as if they had never existed at all. The reported returns of technology mutual funds in 2000, for example, no longer include the results of dozens of failed portfolios that have since gone out of business. Once funds close down, they drop out of the averages that are compiled by firms like Morningstar and Lipper. Including only the funds that survived, and ignoring those that died, the average tech fund lost 30.9% in 2000. But all the tech funds then in existence actually lost an average of 33.1% in 2000.

Counting the winners and skipping the losers can even distort numbers that are taken as gospel truth by investors. It's almost universally claimed that since 1802, U.S. stocks have returned an annual average of 7% after inflation. What no one ever tells you is that the reported track record of U.S. stocks in the early 19th century includes just a tiny fraction of all the companies then in existence. The only stocks included are the winners. Hundreds of companies, in such doomed industries as canals, wooden turnpikes, the pony express, and bird-manure fertilizer, went broke and took their investors with them. If these losers were included in the track record, the average performance of stocks in the early years would drop by roughly two percentage points annually. That doesn't mean that stocks aren't worth owning today, but it does mean that their outperformance is not a certainty—so diversifying with bonds and cash is a necessity. Anyone who claims that history "proves" that young people should put all their money in stocks doesn't know much about history.

The technical term for counting the winners and dropping the losers is "survivorship bias" (because the resulting averages are biased by the success of the surviving companies). Whenever anyone tries to sell you an investment based on long-term "average" performance, ask whether the average has been adjusted for survivorship bias. If the person doesn't know what you mean or cannot clearly explain the result, hang on to your wallet.

DOES IT HAVE LEGS? Rather than focusing only on the fact that something has changed, concentrate on what has changed. Five years from now, will investors look back on it as a watershed, or will no one even remember it? Take some time to evaluate the event that caught you by surprise. How much less should you be willing to pay for this stock or that asset, as a long-term investment, now that something surprising has occurred? Why might the fundamental future health of the business have been damaged? Are there any reasons to believe that this news will impair the earning power of the company? Forget about how the surprise affected the market price of the stock. Instead, focus on what—if anything—it means for the underlying business. Years from now, will customers and suppliers really care whether a company disappointed Wall Street's analysts by one penny per share over the past three months? Now that would be the biggest surprise of all.

CHAPTER NINE

Regret

Clear, unscaleable, ahead Rise the Mountains of Instead.

—W. H. Auden

The Dog in the Rain

To this day, Dan Robertson has an indelible memory of the pain he felt on July 22, 2002, when his portfolio hit rock bottom. Thanks to a series of disastrous bets on Internet stocks and technology funds, Robertson had lost almost exactly $1 million, turning $1,457,000 into $468,000 in less than two and a half years. "I felt like this dog I'd seen once on an L.A. freeway in the rain," recalls Robertson, a retired teacher who lives just north of Los Angeles. "It had been grazed by a car, and it was limping, and the cars kept coming, and then the dog just stopped and looked into the oncoming traffic with this kind of pained smile on its face, like it was thinking, 'It doesn't matter to me whether you hit me or whether you miss me, all I know is I can't run anymore. I can't run anymore.' And I said to myself, 'That's you, Dan. You're just like that dog you saw in the rain.'"

As Robertson knows, losing money on investment mistakes can make you feel almost unimaginably miserable. We saw in Chapter Eight that a negative financial surprise blasts through the reflexive brain like a startle response—quick and astonished, panicky and raw. But then, in the aftermath of a nasty surprise, your reflective brain may take over, generating regret—bitter and contemplative, cold and slow. A surprise makes you exclaim in the heat of the moment, "Uh-oh!" or "Oops!" or "Oh no!" Regret comes in the chilly light of the morning after, when you kick yourself with thoughts like "What on earth was I thinking?" or "How could I ever have believed such baloney?"

Why do some investing decisions fill you with more remorse than others? At least in the short run, your regret is likely to be hotter, sharper, and more painful when:

•the outcome appears to have been caused directly by your own actions, not by circumstances that seem beyond your control;

•you could have chosen other options;

•you came close to your goal, making a "near-miss";

•your mistake was the result of what you did rather than what you did not do, or an error of commission rather than omission;

•and the action you took was a departure from your normal or routine behavior.

One of your hardest tasks as an investor is properly anticipating how much regret you will feel over your mistakes. You can eat yourself up in an endless cycle of "woulda shoulda coulda," or you can let go of your regrets and learn from your errors. It's impossible to invest without making mistakes, but it is possible to stop kicking yourself when you make them. This chapter will show you how.

Are You Well Endowed?

Imagine that I show you something cheap and simple—a plain coffee mug, perhaps. It's not worth a lot of money, it has no sentimental value, and you already have several at home. Would you be interested in buying it? If so, how much would you be willing to pay?

Now imagine that instead of offering to sell it to you, I just give you the mug. It's not a present or a

reward, but it's all yours now. Would you be willing to sell it to someone else? If so, how much would you ask for it?

In theory, your buying and selling prices should be identical. It's the same mug, and you are the same person, regardless of whether you happen to be buying or selling. But countless experiments have shown that people demand a price two to three times higher to sell a mug they have just gotten than they are willing to pay for one they do not yet have. And that includes people who—just like you, probably—insist beforehand that they would never do such a silly thing.

Researchers call this the "endowment effect." What makes you reluctant to sell something you may not have wanted to buy in the first place? Before you buy the mug, you focus on how much money you must give up to get it (and on what else you could do with the money). Thinking about those questions will tend to lower the price you are willing to pay. But once you own the mug and are asked to sell it, you focus more on being asked to surrender something that has become yours (and on what you like about having it). Those questions typically make you jack up the price you are willing to accept for selling. What's more, buying a mug you do not own feels like an act of commission; deciding not to sell one you do own feels like an act of omission. Your instincts tell you that you will feel more regret over a mistake of action than a mistake of inaction. So it's natural to offer less money to buy a mug you don't yet have than you will accept to sell one you do have.

How different are stocks from coffee mugs? Not very. The investments we own tend to seem better to us than those we don't own, even though that isn't always true.

•One firm began enrolling new employees in its 401(k) automatically, with a 3% contribution that went into a money-market fund. Before the change, employees had put roughly 70% of their savings into stock funds. Now that the company plunked all their contributions into the money-market fund, however, the new participants left more than 80% of their assets sitting in that low-return vehicle.

•To encourage employees to save in a 401(k), many firms offer matching contributions. Some make the "match" go automatically into their own stock. Even when employees are free to shift the matching money out of company stock, they rarely do. The companies keep a big slug of their shares out of the grasp of corporate raiders, which makes the financial future of the senior managers more secure. Meanwhile, the financial future of the regular employees who are counting on this money for retirement becomes less secure as they forgo the greater safety of a more diversified portfolio.

•In Sweden, workers who are not ready to choose their own pension investments can have the money placed automatically into a "default" fund, a low-cost index portfolio that blends stocks and bonds. In recent years, roughly 97% of eligible workers have left their money in the default fund, even though they were free to switch at any time to any of more than four hundred other funds. (Luckily, in this case, that's not a bad choice.)

Once you make an investment, you can't help regarding it as yours. You have invested part of yourself in it. The word invest literally means to clothe yourself in something. When you buy a stock, you wrap it around yourself, and it becomes a part of you. From that moment forward, the prospect of having to get rid of it becomes a wrenching thought.

In a psychology lab in Haifa, Israel, 61 people were given lottery tickets, each with an equal chance of winning a prize worth about $25. Before the prize drawing, the participants could trade their ticket for someone else's; if they did, they got a gourmet chocolate truffle. Only 80% of the people actually believed that every ticket had the same chance of winning; 10% thought their own ticket was more likely than others to win, while another 10% felt they held a ticket with less than equal odds. Not surprising, 5 out of 6 people who thought they held a superior chance of winning refused to exchange their tickets. But then came two surprises. First, among the folks who agreed that every ticket was equal, 55% refused to exchange their own for someone else's. And among those who thought their own ticket was less likely

than others to win, 67% still refused to trade for another person's ticket!

What makes people act so strangely? If you trade away your own ticket for another, and then your original one turns out to be the winner, you will feel like a loser and an idiot. On the other hand, if you keep your original ticket and someone else's turns out to win instead, you can just shrug it off. (After all, every other ticket you might have traded for was a loser.) When you imagine your future feelings, doing something that results in a loss feels intensely real and painful. But not doing something—and thereby missing out on a gain—feels much more vague.

Sometimes, investing inertia is a form of avoidance. A lot of people are too intimidated, too busy, or just can't be bothered to devote time and effort to their finances.

•A recent study of the accounts held by 1.2 million 401(k) investors found that 79% never shifted a dime from one fund to another in 2003 or 2004 even as the stock market gained more than 40%.

•A 1986 study examined the decisions of 850,000 people saving for retirement through the TIAA-CREF pension system. Over the course of their investing lifetimes, 72% of the participants never made a single asset-allocation change; they always invested in exactly the same funds they chose at the beginning.

•A later look at more than 16,000 TIAA-CREF accounts found that 73% of the participants made zero changes in asset allocation over a ten-year period; 47% never once changed the proportion of money they put into any fund.

In the financial version of Sir Isaac Newton's First Law of Motion, investors at rest tend to stay at rest unless an outside force acts upon them. Instead of taking action whenever necessary, we do nothing whenever possible. We invest by inertia.

Nobody Loves a Loser

Imagine that you can choose between winning $3,000 for sure, on the one hand, or a gamble with an 80% chance of winning $4,000 and a 20% chance of winning nothing. If you're like most people, you will pick the sure thing.

Next, imagine that you can choose between losing $3,000 for sure, or a gamble with 80% odds of losing $4,000 and 20% odds of losing nothing. What would you do now? In this case, people reject the sure thing and take the gamble 92% of the time.

You would be better off taking the gamble in the first example and the sure thing in the second one—the opposite of what you probably chose. On average, an 80% chance of winning $4,000 is worth $3,200 (.80 x 4,000 = 3,200). So, in the first example, the gamble has an "expected value" $200 higher than the sure thing. By the same rule, an 80% chance of losing $4,000 leaves you $3,200 poorer. And in the second case, you logically should favor the sure loss of $3,000; on average, it will leave you with $200 more.

But it's hard to be strictly logical in these choices, because the idea of losing money triggers potential regret in your emotional brain. If you take the 80% gamble of winning $4,000 and win nothing instead, you will kick yourself for missing out on the $3,000 sure thing. And a 100% chance of losing everything feels a lot worse than the risk of an even bigger loss coupled with a small shot at losing nothing. Doing anything—or even thinking about doing anything—that could lead to an inescapable loss is extremely painful.

That's why football coaches almost always punt the ball on fourth down, even though statistics prove they would usually be better off trying for a first down. Punting is the "sure thing," since it typically backs up the opposing team deep in its own territory. If you don't punt and then turn the ball over, your opponents start off where they can really hurt you. So the fact that you will succeed most of the time on fourth down matters less than the regret you will feel, and the blame you will take, if you fail this time. Likewise, a

baseball manager typically saves his best relief pitcher (the "closer") for the ninth inning. A manager knows that if his best reliever is no longer available in the last inning, and the winning run then scores, he will kick himself (and look like a fool to the fans). But it makes more sense to use the ace in any late inning of a close game, especially when the opposing team's best hitters are coming up to bat. The logical goal is to prevent the winning run from scoring in any inning—but, emotionally, the regret of losing at the last minute is much worse.

The same instinct drives millions of retirement investors to keep their money buried in cash and bonds; they are afraid of the regret they will feel if they invest in stocks right before a market crash. Yet adding stocks to a portfolio of cash and bonds will almost certainly boost returns over the long term.

Avoiding whatever felt like a loss probably helped keep our ancestors alive. Researchers at Yale University trained five capuchin monkeys to trade metal tokens for goodies like apples, grapes, or jello. Two humans—let's call them Seller 1 and Seller 2—traded with the monkeys. For the price of one token, the monkeys could choose to buy either from Seller 1, who offered one apple piece for sure and a 50/50 chance of getting a second one, or from Seller 2, who offered two apple pieces at first, then added a 50/50 chance of losing one of them. The monkeys "traded" dozens of times, long enough to learn that they would always get at least one apple piece and that the average outcome was identical in either case. Nevertheless, the monkeys preferred to deal with Seller 1 fully 71% of the time. Their choice was evidently driven by a desire to avoid the pain of having a bigger reward taken away. The capuchin behavior suggests that loss aversion is very ancient; our most recent common ancestor dates back about 40 million years.

Breaking Up Is Hard to Do

What happens to investors when they are racked with regret? Most people don't panic; instead, they freeze. To understand that paralysis, consider this example:

Paul owns shares in Company A. During the past year he considered switching to stock in Company B, but he decided against it. He now finds that he would have been better off by $2,500 if he had switched to the stock of Company B.

George owned shares in Company B. During the past year he switched to stock in Company A. He now finds that he would have been better off by $2,500 if he had kept his stock in Company B.

Who feels worse? In surveys, an overwhelming 92% of people say George feels more regret than Paul. Almost everyone shares the same powerful intuition: In the here and now, a mistake that stems from an action hurts worse than a mistake that results from inaction. "You were at the secure trunk of the tree," says psychologist Thomas Gilovich of Cornell University, "and then you went out on a limb, and when it gives way you feel like a fool because you didn't need to go out on that limb." And that's why errors so often paralyze investors. After you screw up once, you become afraid of taking another action that could make things even worse. And the only thing worse than losing is having to admit that you're a loser. So, while most investors are only too eager to cash in on their gains, they hate to sell an investment when it's down, since selling turns a "paper loss" into a real one.

Under U.S. tax law, that makes no sense. When you sell a winner, you turn a paper profit into a taxable capital gain (and, if you hold it for less than twelve months, it is taxable at up to 35%). Meanwhile, clinging to a loser keeps you from taking it as a tax deduction. Hanging on makes sense only if you have determined that the value of the business is greater than the price of the stock.

As is so often the case, however, what makes no economic sense makes perfect emotional sense. "When you sell a loser," explains psychologist Daniel Kahneman, "you don't just take a financial loss; you take a psychological loss from admitting you made a mistake. You are punishing yourself when you sell." On the other hand, says Kahneman, "Selling a winner is a form of rewarding yourself."