Don't Let Bad News Guide Your Investments

If it bleeds, it leads.

Turn on the local TV news and you're very likely to see videos of house fires, car crashes, and crime scenes. Why doesn't the evening news show pictures of houses under construction, cars politely paused at crosswalks, and folks checking out at the grocery store? Of course, the other familiar journalistic cliché about a man biting a dog provides part of the answer. News is about the unusual, the "newsworthy," and not the ordinary. But there's another reason the news mix favors the troubling rather than the reassuring, and it has important implications for the kinds of news stories investors are likely to read and see. To explain, I'll need to dip into a bit of economic research.

In recent years the study of behavioral economics has increasingly influenced the way we think, or should think, about economic and investing decisions. Advances in this relatively new discipline won a Nobel Prize in economics for psychologist Daniel Kahneman in 2002. The economics most of us learned--left, right, or whatever--assume the world is made up of rational utility maximizers, the sort of folks who make decisions with the exclusive objective of getting the greatest benefit at the least cost. Behavioral economics asks us to recognize that our fears, dreams, and instincts will lead us to act in ways that aren't so neatly rational, and simply ignoring deviations from the "rational actor" model will lead us to significantly misunderstand the ways real decisions are made.

In his broad-ranging book on the subject, Thinking, Fast and Slow, Kahneman devotes a chapter, "Bad Events," to one of the most basic findings of behavioral economics, our tendency to weigh a loss more heavily than we weigh an exactly equivalent gain. Writers usually illustrate the point by reporting experiments in which participants only accept a fair bet on a random event (such as the toss of a coin) if the payoff for winning is greater than the cost of losing; we value the dollar we might lose more than we value the dollar we might win. Kahneman offers several examples of this seemingly irrational imbalance in our judgment--one cockroach on a bowl of cherries affects us more than one cherry on a bowlful of insects--and reports the more surprising statistical finding that professional golfers putt more successfully to avoid bogies (a stroke over par) than they do to make birdies (a stroke under par) even though the net effect on their score for the round changes by one stroke either way.

We hate to lose and will react much more forcefully to threats than to opportunities. That all-too-human response can create some significant risks to investors' financial well-being. It also explains why we are likely to hear much more bad news than good.

As I write this, I'm trying my best to avoid boring you and to keep your attention. Since the editors surely won't let me do that by appealing to prurient interests, which would be the surest attention grabber, I might resort to the next best emotional switch and appeal to your fears. If I tell you that the economy will fall off the fiscal cliff into a deep recession, that central banks are drowning the global economy in fake money, that the Chinese economy is crashing and civil disorder will follow, I'll surely have your attention. But if I tell you instead that the U.S. economy is approaching a period of modestly higher taxes and significantly slower growth in government spending, that central banks have in large part replaced the money destroyed as households and the financial system deleveraged, and that China's economy is slowing to a sustainable level, you'd likely call me boring. You'd also have a much firmer basis for making investment decisions.

We all fear and therefore pay more attention to looming, if improbable, disasters than we do to evidence of gradual improvement in what's been an unusually, even historic, period of economic trouble. The boring facts are that the U.S. economy is growing, employment is increasing, household balance sheets are improving, and businesses are making money. Of course, none of those positive developments are moving ahead fast enough. We still live with the overhang of a generational financial crisis, and we will debate for decades whether government policy made the situation better, worse, or just more costly. And a failure to resolve our polarized political stalemate could jeopardize the grudging progress we've made. Nevertheless, we will build far more houses than we burn down, and canines will continue to dominate in the biting competition even though we will read and hear more about the exceptions than the typical.

The question is what we do with those newsworthy stories and how we contain the fear that they can cumulatively inspire. The answer is to make reasonable provision and then proceed to enjoy the more probable outcomes a rational assessment of risk would reveal. Houses catch fire, and every one of them should have lightening arrestors, but we don't all have to live in caves to be safe.

Jerry Webman is the author of MoneyShift: How to Prosper from What You Can't Control and Chief Economist at OppenheimerFunds.



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