Zweig, Jason. Your Money and Your Braine

So a financial advisor can goad you into taking (or avoiding) an investment risk just by changing how he describes it. If he boots up some fancy software that says you have a 78% chance of meeting your retirement goals, that sounds great. But he can reframe the same result and strike fear into your heart by declaring that "22 out of 100 people with your strategy will end up eating cat food in the dark"—and the next thing you know, he has foisted a bunch of risky stocks onto you that you never wanted.

As the study of doctors considering cancer treatment showed, experts can fall prey to framing problems just as easily as amateurs can. Whether you are a retail investor or a professional money manager, your "risk tolerance" is supposed to be an integral part of your personality. But it can be transformed by an embarrasingly basic twist in wording. That's why every investor must be eternally vigilant against the dangers of getting framed.

The Blundering Herd

Your perception of investment risk also depends on peer pressure. If I had a dollar for every time I've heard a money manager brag about being a "contrarian" or "not following the crowd" or "loving the stocks that everybody else hates," I could almost live off the interest alone. The most obvious similarity among money managers is their insistence that they are all different. In truth, they act like the multitudes in Monty Python's Life of Brian. When Brian exhorts the crowd, "You are all individuals," they chant, "Yes, we are all individuals!" When he tries again, telling them "You are all different," they roar in unison, "Yes, we are all different!"

Do investors really act like individuals?

•A study of thousands of buy or sell recommendations by security analysts at hundreds of brokerages found that analysts tag along with the crowd as if they were coated with Velcro. When the average recommendation is a "strong buy," for example, the next call from any given analyst is about 11% more likely to be a strong buy, too.

•When individual investors raise their average holdings in a stock by 10 percentage points, people who live within a fifty-mile radius of the buyers jack up their own stakes in the same stock by an average of two percentage points.

•In rising and falling markets alike, hedge funds—those exclusive pools of "sophisticated" money run by supposedly independent-minded investors—mimic each other's trades like teenagers trawling through a shopping mall.

•Looking at retirement-plan decisions by 12,500 employees of a major university, researchers found that people working in the same department tended to invest in funds from the same firm, even though every employee could choose freely from four different fund companies.

•In 1995, New Era Philanthropy, a scam run by John G. Bennett Jr., collapsed after conning more than $100 million out of universities, churches, and foundations. Bennett had set the trap by promising to double their money every six months. Word of his wonders had spread quickly among the tycoons who sit on nonprofit boards—and Bennett soon had bilked millions out of venture capitalist Laurance Rockefeller, former U.S. Secretary of the Treasury William Simon, and hedge fund manager Julian Robertson. Separately, these men were among the smartest investors in America; as a herd, they acted like a bunch of dolts.

•Institutional investors like insurance companies, foundations and endowments, pension funds, and mutual funds spend billions of dollars every year researching which stocks they should buy and sell. All this spadework should unearth buried treasure—rare and unusual stocks that no one else knows about or can understand. Instead, the institutions scratch the same surfaces. On average, an institutional investor is 43% more likely to increase its holdings of a stock if, over the previous three months, other big investors

trading the stock were all buyers.

• When institutions own a hot stock in a trendy industry, they usually have heard of it by word of mouth rather than through original research—and they go on to talk it up with three times as many colleagues as the owners of less exciting stocks do. No wonder "everybody" often seems to be talking about the same stock.

Ideas, like yawns, are contagious. (I may well be able to make you yawn just by asking you to read this sentence containing the word yawn.) Let's say you need to rent a car at the airport. There are two people ahead of you in line and a sign announcing that only two kinds of cars are available: Hyundai or Fiat. Your hunch is to go with a Hyundai, but you don't know a lot about cars—and you've never driven either a Hyundai or a Fiat. So you watch the folks in front of you. The first confidently picks a Fiat—so it looks as if she knows what she's doing. Then the second person steps forward, hesitates, and asks for a Fiat.

Now it's your turn. What do you do? You should bear in mind that the first renter seemed sure of her choice, while the second didn't seem any more ignorant than you. Since both of them picked a Fiat, you probably should stifle your own hunch and pick a Fiat, too. So you say firmly, "I'll take a Fiat." Their choice has spilled over onto yours—and now yours will splash over onto the person behind you, triggering what's called an "information cascade" that can wash over everyone in the line and create a wave of demand for Fiats.

The cascade may well continue until someone who seems to be an expert finally steps up and demands a Hyundai. If the next person does the same, now everyone behind him who was leaning toward a Fiat will ask for a Hyundai. It doesn't take much new information to send a cascade sloshing in the opposite direction.

Informational cascades are not necessarily irrational. If you really don't know much about automobiles, you should try to figure out who does and take your cue from them, especially when you have to make a decision on the spot and have no time to learn more on your own. It's a simple guideline for making simple choices when you know you don't have all the information you need.

In fact, what ecologists call "public information"—the contagious spread of cues about risk and reward—is one of the most basic techniques that living things use to enhance their chances of survival. Incredible as it may seem, even some plants have developed the ability to share public information about the presence of risk: When sagebrush is damaged by animals, it releases aromatic chemicals, alerting nearby plants to step up their own production of defensive proteins that deter grasshoppers and other critters that munch on vegetation. And in the animal kingdom, creatures of all sorts band together —schools of fish, flocks of birds, herds of sheep, packs of wolves, pods of whales—to feed, migrate, fend off enemies, and learn from each other about risks and rewards.

Starlings, for example, rummage for food along the surface of the ground. They probe most painstakingly when they are alone. However, in the presence of at least one other starling, they quickly learn to skip over areas that are more difficult to evaluate—focusing on the patches where the behavior of the other birds suggests food is most likely to be found. Among fish, species of sticklebacks with smaller spines and softer bodies take more cues from the feeding patterns of other fish to locate the best places to forage. But stickleback species with tougher, spikier bodies explore much more independently for food. Animals seem more inclined to let others do some of their thinking for them when their own information is incomplete, outdated, or if they feel vulnerable.

Humans are animals, too. When people form investing herds, we crowd together to buy a stock, cheerlead its rise, and egg each other on. Just like starlings, we become less willing to venture off on our own—and merely being part of a group makes us less inclined to ask questions.

When investors pile into smaller stocks and newer industries, they become more willing to admit that

someone else may know something they don't. Just like the run of Fiats or Hyundais in the rental car line, the result is an informational cascade, with everyone in the group buying the same stocks at the same time. "The trend is your friend," brokers have long told their clients. "Don't fight the tape." Being part of the herd is fun while it lasts, but it's seldom lucrative for very long, and it's impossible to predict when the herd will change its "mind." If you want to make more money than other people, you can't invest like other people.

Throwing a "Hail Mary"

How much money you made or lost on your last investments can transform how risky you think the next one is. The same bet can feel either dangerous or safe, depending on whether you are on a hot streak or in a slump. That's how your investing brain is designed.

Animals that are running low on food, water, or warmth have what ecologists call a "negative energy budget." Creatures that are hungry, thirsty, or cold can rarely afford to take the chance that small but steady gains will be enough to keep them alive. In effect, they need to try striking it rich. So animals in a state of deprivation tend to prefer more variable rewards: While that raises the risk of getting nothing, it's also the only feasible way to get the big boost they need to restore their depleted energy.

Biologist Thomas Caraco offered two different trays of millet seeds to yellow-eyed juncos, a bird native to Mexico and the southwestern U.S. One tray—let's call it the "risky" choice—provided either several millet seeds or none at all. The other tray—the "certain" option—always offered a constant amount of food. (If, for example, the first tray contained either zero or four seeds, then the second tray always provided two seeds; if the risky tray offered either zero or six seeds, then the certain tray always held three seeds; and so on.) When the juncos had recently been fed, they preferred the certain choice: the tray with the fixed, smaller amount of food. But when the birds had not eaten anything for a few hours, they became risk-takers, pecking at the tray that offered either double or nothing.

If birds run out of seeds, they might not survive. If humans run out of money, we also might not survive —because without it we might not be able to obtain the necessities of life. The less money people have, the more willing they often become to take on extra risk, just as a quarterback will throw a "Hail Mary" pass late in the fourth quarter or a basketball player will launch a desperate shot from half-court just before the final buzzer sounds. All too often, a "negative energy budget" makes people fling a Hail Mary with their money. Sometimes the results are heartbreaking, as in Manila in 2006, when seventy-nine impoverished Filipinos were trampled to death in a panic to get raffle tickets for a cash giveaway.

Even when no one dies, the sad fact is that those who can least afford to lose the little money they have are most prone to put it at high risk.

•In Virginia, residents who earn less than $15,000 per year spend 2.7% of their annual income on lottery tickets, while those who make more than $50,000 per year use only 0.11% of their income to play the lottery.

•When more than 1,000 Americans were asked to pick the most practical way to become wealthy, 21% said "win the lottery." Among those with incomes of $25,000 or less, nearly twice as many felt that their best chance at getting rich was a lottery ticket.

•Blacks and Hispanics are more reluctant than whites to take moderate financial risks—yet nonwhites are between 20% and 50% more willing to take substantial financial risks. Black and Hispanic households, on average, have roughly one-fourth the total net worth of the typical white household.

•In the second half of the year, mutual funds with below-average returns become up to 11% more volatile than those that had above-average results in the first half. Consciously or not, the managers of funds that lagged in the first six months buy riskier stocks in an attempt to salvage their returns by year-end.

•On average, when professional "market makers" at the Chicago Board of Trade lose money in the morning, they take extra risk that afternoon—making bigger bets and trading faster until it seems that their underpants are on fire.

•Poorer investors—those with an estimated net worth under $75,000—favor stocks that offer the same promise as lottery tickets: a low price and a small chance at striking it rich, plus a high risk of loss. By gambling on these long-shot stocks, the poorest investors fall behind the overall stock market by an average of roughly 5% of their annual income. Thus the very people who can least afford them take the worst risks. At the same time, they lack the resources to get advice that might help them invest more prudently.

Making Risk Work for You

Bobbi Bensman, the champion rock climber we met at the beginning of this chapter, knows that dangling off cliffs can be deadly to climbers who don't think clearly. But if you learn how to control the likeliest sources of danger, rock climbing becomes surprisingly safe. Investing is like that, too. Here are some reliable policies and procedures you can put in place ahead of time to help you manage your risks instead of letting them manage you.

TAKE A TIME-OUT. Since even the most minor, momentary changes in your mood can make a huge difference in how you perceive risks, don't buy or sell an investment on the spur of the moment. You may be under the sway of temporary influences you're not even aware of. A road-rage encounter on your way to work, a fight with your spouse, background music that bothers (or pleases) you, a flash of red or a cool wash of blue—any of these things could skew the way you think about an investment. Sleep on it until tomorrow, and see whether you view it the same way.

STEP OUTSIDE YOURSELF. In the mid-1980s, Intel Corp.'s main business, manufacturing memory chips, was collapsing under fierce competition from Japan. The company's profits fell by more than 90% in a year. Torn between the pain of the status quo and the fear of change, Intel's managers were paralyzed. At that point, recalls then-president Andy Grove,

I looked out the window at the Ferris wheel of the Great America amusement park revolving in the distance when I turned back to [CEO Gordon Moore], and I asked, "If we got kicked out and the board brought in a new CEO, what do you think he would do?" Gordon answered without hesitation, "He would get us out of memories." I stared at him, numb, then said, "Why shouldn't you and I walk out the door, come back, and do it ourselves?"

By stepping outside themselves, Grove and Moore got the insight to see which risk was right—and the courage to take it. Intel moved out of memory chips and into microprocessors, a bold and brilliant leap that powered its growth for years to come.

Knowing, or even imagining, that someone else is relying on your advice can make you feel more accountable, forcing you to go beyond your gut feelings and fortify your opinions with factual evidence. After the terrorist attacks of September 11, I got dozens of e-mails from panicky readers asking me whether they should get out of the market. Stifling my own gut feelings of fear and rage, I answered as analytically as I could, gathering historical evidence on how the U.S. stock market had performed after earlier national tragedies. My conclusion: "The modern financial history of the U.S. holds no example of a physical disaster, or even an outright war, that wreaked lasting havoc on investment returns." Within a year, the bear market was over—and anyone who got out in September 2001 missed one of the best buying opportunities in a generation.

If you find it hard to imagine stepping outside yourself, try an exercise anyone can relate to. Before concluding that an investment decision is right for you, ask whether you'd be comfortable advising your mother to do the same thing. If you would tell her not to do it, then why should you do it? I call this the WWMD question (What Would Mom Do?).

LOOK BACK. If you have never lived through a bear market like 2000–2002 or 1973–74, it's easy to delude yourself into thinking you have nerves of steel. Every novice investor should study enough financial history to know that booms always end in busts—and that the cockiest traders die first. (Two good books are Edward Chancellor's Devil Take the Hindmost and Charles P. Kindleberger's Manias, Panics, and Crashes.)

WHEN THE PRICE DROPS, RISK GOES WITH IT. Long ago, the financial analyst Benjamin Graham pointed out that most people measure what a stock is worth by looking at its price, while they judge what a business is worth by calculating its value. That leads to huge differences in how people think:

"The main reason investors struggle with how to react to bad news," says Oakmark Fund manager Bill Nygren, "is that they really haven't figured out why they own the stocks they own. If you buy a stock primarily because it has been going up, and then it falls on bad news, it shouldn't come as a surprise that your gut instinct is to sell."

This emotional mix-up arises because once a business sells shares to the public, nearly everyone focuses on the fast-moving price of the stock and forgets about the much more stable value of the business. Thus, when the stock price drops, it seems like bad news. As BusinessWeek put it during the heart of a bear market long ago, "For investors…low stock prices remain a disincentive to buy." But if the value of the business is solid, a declining stock price should be an incentive to buy, because it enables you to get more shares for less. And if the stock price drops below the business value, you have that rare opportunity that Graham called a "margin of safety"—the assurance that you can increase your stake for less than what it is actually worth.

I've often said that the problem with stocks is that little letter T. If you take the T out of stocks, you're left with socks. They have almost nothing in common:

Would you ever pay $500 or $1,000 for a pair of socks without asking how they could possibly be worth so much? Would you be upset if your favorite store started selling socks at 50% off? Of course not. But when it's stocks instead of socks, people make those mistakes all the time.

Once the pain and fear of loss kick in, it can be nearly impossible to think calmly enough to use your reflective brain to figure out the right course of action. But in the face of falling share prices, you must

systematically analyze whether bargains are being created. That's why it's so important to plan ahead. Buying a stock without first calculating the value of the underlying business is as irresponsible as buying a house without ever setting foot inside. And you should never sell a stock without first asking whether a falling share price has made it a better investment than ever.

WRITE YOURSELF A POLICY. The best way to prevent yourself from being knocked off track by your emotions is to spell out your investing policies and procedures in advance, in what's called an "investment policy statement," or IPS. An IPS states what you, as an individual or an organization, are seeking to accomplish with your money and how you will get there. It lists your objectives down the road as well as your constraints along the way. (For a sample IPS, see Appendix 3.) Once you create an IPS, you must live by it; it is your contract with yourself or your organization. You can put extra "teeth" into your IPS by programming your Palm, BlackBerry, or desktop calendar software to send yourself periodic warnings not to violate your own investment policy.

GET REFRAMED. The German mathematician Karl Jacobi had useful advice: "Invert, always invert." Explains the investor Charles Munger: "It is in the nature of things, as Jacobi knew, that many hard problems are best solved only when they are addressed backward." If someone tells you that the odds of success are 90%, invert the frame like this: That means there's a 10% chance of failure. Is that too high for you? Next, flip the percentage frame into a personal one: One out of every ten people who try this will fail. How do I know I won't be the one? If you are part of a large organization, break your researchers into groups and have each one report its findings in a different frame. Seeing risk estimates in both percentage and personal terms will help you make a more balanced decision.

You should also fit the evidence into the widest frames you can. Let's say you have a total of $24,000 invested in stocks. Now you're considering putting $1,000 into a stock that you believe has even odds of either doubling or going to zero. Thinking of it in a narrow frame—I could either make $1,000 or lose $1,000—turns the decision into a tug of war between greed and fear. Instead, put it in a broad frame: The total value of my portfolio could either go up to $25,000 or down to $23,000. That broader frame will take most of the emotion out of your choice.

TRY TO PROVE YOURSELF WRONG. "The riskiest moment is when you're right," says investing sage Peter Bernstein. "That's when you're in the most trouble, because you tend to overstay the good decisions." That refusal to second-guess yourself can lead to huge losses and a crippling sense of regret. So it's a good idea to schedule an advance appointment with a devil's advocate. Make a rule: Whenever an investment doubles in price, find out who has the most negative view of it and give this devil's advocate a full hearing. Read or listen to the critique, take careful notes, then factor the devil's advocacy into a fresh comparison of price and value. If the price no longer makes sense, it's time to sell.

KNOW YOURSELF. Most exercises designed to test your "risk tolerance" are a waste of time. As we have seen, your reaction to risk is not a single thing, fixed and unchangeable, like an isolated insect preserved in amber. Instead, you house a multitude of potential responses—ranging from rigid fear to feelings that stretch like taffy. Your attitudes toward financial risks, as we have learned, can differ drastically depending on how they are framed, whether you are alone or in a group, how your previous bets paid off, how easy it is for you to think about the risk, what mood you are in, even what the weather is like outside. The slightest change in any of those factors can raise or lower your tolerance for risk in a heartbeat. Even so, there's still plenty you can do to manage your attitudes toward risk.

•Bear in mind that when most people say they have "a high tolerance for risk," all they really mean is that they have a high tolerance for making money. It's easy to feel comfortable with the risks you took when they all seem to be paying off. But when the gains vanish and the losses swell, the harvest of risk is nothing but heartbreak. If you think a plunge in the value of your investments won't bother you, you are either wrong or abnormal.

•Economists used to say that "rational" people should pay the same amount for a chance to win $100 or

Here are a few questions that might, at first, seem silly.

•Which is riskier: nuclear reactors or sunlight?

•Which animal is responsible for the greatest number of human deaths in the U.S.? –Alligator

–Bear

–Deer

–Shark

–Snake

•Match the causes of death (on the left) with the number of annual fatalities worldwide (on the right): 1. War a. 310,000

2. Suicide b. 815,000

3. Homicide c. 520,000

Now let's look at the answers.

The worst nuclear accident in history occurred when the reactor at Chernobyl, Ukraine, melted down in 1986. According to early estimates, tens of thousands of people might be killed by radiation poisoning. By 2006, however, fewer than 100 had died. Meanwhile, nearly 8,000 Americans are killed every year by skin cancer, which is most commonly caused by overexposure to the sun.

In the typical year, deer are responsible for roughly 130 human fatalities—seven times more than alligators, bears, sharks, and snakes combined. How could gentle Bambi cause such bloodshed? Unlike those other, much more fearsome animals, deer don't attack with teeth or claw. Instead, they step in front of speeding cars, causing deadly collisions.

Finally, most people think war takes more lives than homicide—which they believe kills more people than suicide. In fact, in most years, war kills fewer people than conventional homicides do, and the number of people who take their own lives is almost twice the number of those who are murdered. (In the list on the previous page, the causes and the number of deaths that result from them are already matched correctly.) Homicide seems more common than suicide because it's a lot easier to imagine someone else dying than it is to imagine killing yourself.

None of this means that nuclear radiation is good for you, that rattlesnakes are harmless, or that the evils of war are overblown. What it does mean is that we are often most afraid of the least likely dangers, and frequently not worried enough about the risks that have the greatest chances of coming home to roost. It also reminds us that much of the world's misfortune is caused not by the things we are afraid of, but by being afraid. The most terrible devastation wrought by Chernobyl, for example, did not come out of its nuclear reactors. Instead, it came from the human mind. As panicky business owners fled the area, unemployment and poverty soared. Anxiety, depression, alcoholism, and suicide ran rampant among the residents who could not afford to leave. Fearing that their unborn babies had been poisoned, expectant mothers had more than 100,000 unnecessary abortions. The damage from radiation was dwarfed by the damage from the fear of radiation, as imaginary terrors led to real tragedies on a massive scale.

We're no different when it comes to money. Every investor's worst nightmare is a stock market collapse like the Crash of 1929 that ushered in the Great Depression. According to a recent survey of 1,000 investors, there's a 51% chance that in any given year, the U.S. stock market might drop by one-third. And yet, based on history, the odds that U.S. stocks will lose a third of their value in a given year are only around 2%. The real risk is not that the stock market will have a meltdown, but that inflation will raise your cost of living and erode your savings. Yet only 31% of the people surveyed were worried that they might run out of money during their first ten years of retirement. Riveted by the vivid fear of a market Chernobyl, they overlooked the more subtle but severe damage that can be dealt by the silent killer of inflation.

If we were strictly logical, we would judge the odds of a risk by asking how often something bad has actually happened under similar circumstances in the past. Instead, explains psychologist Daniel Kahneman, "we tend to judge the probability of an event by the ease with which we can call it to mind." The more recently an event has occurred, or the more vivid our memory of something like it in the past, the more "available" an event will be in our minds—and the more probable it will seem to happen again. But that's not the right way to assess risk. An event does not become more likely to recur merely because its last occurrence was recent or memorable.

Just say these words aloud: airplane crash. What do you see in your mind's eye? Chances are, you imagine a smoky cabin filling with screams, a bone-shattering crunch, a giant fireball pinwheeling down a runway. In principle, says Paul Slovic, a psychologist at the University of Oregon, "risk is brewed from an equal dose of two ingredients—probabilities and consequences." But in practice, when we perceive the risks around us, the doses of those two ingredients are not always equal. Since the consequences of a crash can be so horrific, while the probabilities of a crash evoke no imagery at all, we get zero comfort from the fact that the odds against dying in a U.S. plane crash are roughly 6,000,000 to one. Those images of death are scary, while "6,000,000 to one" is an abstraction that conveys no feeling at all. ("I don't have a fear of flying," the basketball player Toni Kukoc once said. "I have a fear of crashing.") Once again, the emotional force of the reflexive brain overwhelms the analytical powers of the reflective brain.

On the other hand, we feel perfectly safe—if not immortal—when we're behind the wheel of our own car. Many travelers think nothing of having a couple of beers, then climbing into their car and driving to the airport with a cell phone in one hand and a cigarette in the other. Many of them even worry about whether their plane might crash—and remain utterly blind to the ways their own behavior is riddled with risk. The numbers tell the story: Only 24 people died on commercial aircraft in the U.S. in 2003, while 42,643 people were killed in car accidents. Adjusting for the distance traveled, you're about 65 times more likely to die in your own car than in a plane. And yet it's air travel that frightens us. Over the twelve months after the terrorist attacks of September 11, 2001, the fear of flying put far more people onto U.S. roads, causing an estimated 1,500 extra deaths in car crashes.

The more vivid and easily imaginable a risk is, the scarier it feels. People will pay twice as much for an insurance policy that covers hospitalization for "any disease" than one that covers hospitalization for "any reason." Of course, by definition, "any reason" includes all diseases. But "any reason" is vague, while "any disease" is vivid. That vividness fills us with a fear that makes no economic sense. However, it makes perfect emotional sense.

The emotion generated in our reflexive system can shove our analytical abilities aside, so the presence of one risk can make other things seem riskier, too. In the wake of September 11, for example, the Conference Board's Consumer Confidence Index, a measure of how Americans feel about the economic outlook, slumped by 25%. And the number of people who said they planned to buy a car, a home, or a major appliance in the coming six months dropped by 10%.

When an intangible feeling of risk fills the air, you can catch other people's emotions as easily as you can catch a cold. Merely reading a brief newspaper story about crime or depression is enough to prompt people into more than doubling their estimates of the likelihood of unrelated risks like divorce, stroke, or exposure to toxic chemicals. Just as when you have a hangover the slightest sound can seem deafening, an upsetting bit of news can make you hypersensitive to anything else that reminds you of risk. As is so often the case with the reflexive brain, you may not realize that your decisions are driven by your feelings. Roughly 50% of people can recognize when they have been disturbed by a bit of negative news, but only 3% admit that being upset may influence how they react to other risks.

Our intuitive sense of risk is driven up or down by what Paul Slovic calls "dread" and "knowability." Those two factors, he explains, "infuse risk with feelings."

•Dread is determined by how vivid, controllable, or potentially catastrophic a risk seems to be. Repeated surveys have found that people consider handguns a bigger risk than smoking. Because we can choose not to smoke (or choose to quit if we do), the hazards of smoking seem to be under our control. But there's not much you can do to prevent some thug from putting a bullet through your head at any moment, and TV cop shows pump your living room full of gunshots every night—so handguns seem scarier. Yet smoking kills hundreds more people than handguns do.

•The "knowability" of a risk depends on how immediate, specific, or certain the consequences appear to be. Fast and finite dangers (fireworks, skydiving, train crashes, etc.) feel more "knowable" (and less worrisome) than vague, open-ended risks like genetically modified foods or global warming. Americans rate tornadoes as a much more frequent killer than asthma. Because asthma moves slowly and many of its victims survive, it seems less dangerous, even though it kills many more people. If the consequences of a risk are highly uncertain and poorly understood, any perceived problem can trigger a frenzy of publicity. Thus hedge funds, those giant investment pools that operate in almost complete secrecy, become front-page news whenever they lose money.

Dread and knowability come together to twist our perceptions of the world around us: We underestimate the likelihood and severity of common risks, and we overestimate the likelihood and severity of rare risks—especially if we have never personally experienced them. When we feel we are in charge and we understand the consequences, risks will seem lower than they truly are. When a risk feels out of our hands and less comprehensible, it will feel more dangerous than it actually is. It's as if we see the world through warped binoculars that not only magnify whatever is remote but shrink whatever is near.

That's why so many people buy flight insurance at the airport: The chance of dying in a plane crash is almost zero, and most passengers are already covered by life insurance anyway, but air travel still feels risky. Meanwhile, roughly three-quarters of all Americans living in vulnerable areas have no flood insurance. Because homeowners can readily see how high the water has risen in the past, and because they can easily invest in drainage systems and other techniques that seem to control the risk of flooding, they feel safer than they really are. Hurricane Katrina exposed how dangerous this feeling of safety can be.

In the stock market, these quirks of risk perception can be a big distraction. On March 22, 2005, a woman named Anna Ayala was eating at a Wendy's restaurant in San Jose, California. She spooned a helping of chili into her mouth, started to chew, and then spat out a human finger. When the news broke, Wendy's stock fell 1% on heavy trading volume, and by April 15, 2.4% had been chopped off the market value of the stock. Customers turned away, costing the company an estimated $10 million in revenues. But investigators soon found that Ayala had planted the finger (which one of her husband's coworkers had lost in an industrial accident) in the bowl of chili herself. Wendy's business recovered steadily, and anyone who sold the stock in the initial panic was left feeling like somebody with ten thumbs, as it nearly doubled over the coming year.

Much the same thing happened in June 1999, when eBay's website crashed and "went dark" for twenty-two hours. Trading in Beanie Babies and G.I. Joes ground to a halt, costing eBay about $4 million in lost fees and causing consternation among thousands of buyers and sellers. Over the next three trading days, eBay's shares fell 26%, a loss of more than $4 billion in market value. Because the Internet was still relatively young, many investors had no idea when eBay could fix the problem—so the consequences seemed highly uncertain, arousing enormous fear. But eBay's site was soon running smoothly, and the stock almost tripled over the next five years.

In short, overreacting to raw feelings—"blinking" in the face of risk—is often one of the riskiest things an investor can do.

The Hot Button of the Brain

Deep in your brain, level with the top of your ears, lies a small, almond-shaped knob of tissue called the