Thinking straight is practically impossible when money's at stake

LONDON - One of the enduring mysteries of the finance world is also one of the simplest. How do seemingly intelligent, well-educated people make so many bad decisions?

New research confirms what many of us had suspected all along.

Most managers find it virtually impossible to think straight. So do most investors. They keep letting their emotions and their pride get in the way.

As long as that's true, bad calls will still be made.

Nobody who follows business or finance will need much convincing that the truly terrible decision is as common as it has always been.

What, we wonder, can have possessed a smart fellow like former DaimlerChrysler chief executive officer Juergen Schrempp to think that he could make a go of running Chrysler, even though plenty of United States car executives had tried and failed?

How come alpha-style managers at Time Warner convinced themselves that merging one of the United States' oldest and most-respected media businesses with an internet company - America Online - that had an unclear future, and not much in the way of profits, was a good idea?

The next few years will no doubt bring a fresh crop of examples.

Meanwhile, in investment, intelligent life is rarely to be found even in the best-managed funds. Little else can explain the determination to keep running up the prices of commodities this year, long after that market had turned into a bubble.

In short, the bad call is as common, if not more so, than the good call.

Two recent pieces of academic research throw some light on why that is so.

At Britain's Royal Economic Society annual conference this week, Felix Hoeffler, senior research fellow at the Max Planck Institute for Research on Collective Goods in Bonn, is presenting a paper titled Why Humans Care About Sunk Costs While Animals Don't.

His argument is that human beings care too much about "sunk costs" or what he calls "the Concorde fallacy".

Concorde was the Anglo-French supersonic passenger jet of the 1970s. It became clear fairly early on that the plane was an economic disaster - it was far too noisy and far too expensive. And yet the British and French governments continued to pour money into the project, even though there was no chance of getting it back.

Many of us do something similar with our own portfolios. We buy a share, watch it sink, then cling to it in the hope it might perk up one day.

"Everyday experience tells us that humans are vulnerable to sunk cost behaviour," Hoeffler says in the report.

"When we buy a ticket for the opera and - on the evening of the performance - recognise that there is an interesting football match on TV, which we would actually prefer to watch, we feel somehow obliged to go to the opera in order to avoid the sense that we have 'wasted' the money on the opera ticket."

Most of us are probably familiar with that feeling. Essentially, we let our emotions get in the way of making the right decision.

Curiously, says Hoeffler, animals don't make the same mistake. They are much more willing to cut their losses when performing a task than we are.

There is growing evidence that emotion commonly stands in the way of rational decision-making in business.

Last year, a study found that people suffering from a certain type of brain damage were a lot better at making investment decisions than other people.

A team from Stanford University, Carnegie Mellon University and the University of Iowa looked at the investment decisions made by people who were unable to feel emotions because of brain lesions, yet who otherwise were completely normal. It then experimented to see how they compared with people who did feel emotions.

The result? The people who didn't feel emotions did a lot better than the others.

"Investors are not behaving in their own best financial interest," Baba Shiv, an associate professor of marketing at the Stanford Graduate School of Business and co-author of the study, said in a report on its results. "Something is going on that can't be explained logically."

In that experiment - which got people to bet on the toss of a coin - most "normal" people stopped investing at a certain point because they were afraid of losing the money they had already made.

The brain-damaged participants didn't feel any fear, so they carried on investing and made more money.

Once again, for the "normal" people, emotions got in the way of making the right financial decision.

It is the flipside of the phenomenon Hoeffler is investigating. We stick with our bad investments because we are embarrassed to admit that we have made a mistake. We are too proud.

And then we get rid of our winning investments because we are frightened of losing the money we have already made.

In the end, it appears, we end up making bad calls because we're human.

So long as that's true, really terrible mergers will still be struck. Funds will pour money into markets at their peak. Perhaps it's time to give some robots a chance - or just put the monkeys in charge, literally.

- BLOOMBERG