Bad Decisions in Bad Economic Times

Maybe your investments have taken a beating or the bank has cut your home-equity line of credit in half. Or you just spent $100 to fill your gas guzzler's tank. A lot of financial stress is going around these days, which puts us in particular danger of making stupid mistakes.

You'd think the opposite would be true -- that we'd get more conservative with our money when we're feeling pinched. But smart people who study such things know how fragile we are when it comes to holding on to what we have. "Investors will endure all kinds of risks, crazy risks," to maintain the status quo, says Don Moore, a professor of organization behavior at Carnegie Mellon.

A recent study by Moore's colleagues shows just how easily we can be induced to take risks. In the study, a series of questions made participants feel either relatively poor or relatively wealthy. Those made to feel poor were asked to peg their income on a scale that started at "less than $100,000" and went up in $100,000 increments. Most landed in the bottom tier. The scale for those made to feel wealthy started at "less than $10,000" and went up in $10,000 increments. Most participants ended up in the middle to upper tiers.

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Once they were primed to feel rich or poor, they were either paid $5 for participating or given the option of receiving up to five lottery tickets. The "downtrodden" chose twice as many tickets as those who'd just had their financial egos massaged. "People are often willing to go double or nothing to avoid feeling that they're losing," says Moore.

In addition to psychology working against us, we are also biologically programmed to make poor decisions under stress. Psychiatrist Richard Peterson points out that stress hormones affect our brains to make us short-term, impulsive thinkers when financial problems often call for long-term, creative solutions. Peterson runs a hedge fund based on "emotional arbitrage" -- he buys stocks laden with dire predictions, and sells ones with too much upbeat buzz.

He also counsels financial advisers on how to deal with clients' emotions. One thing he preaches: Don't fight biology. "People need to take action because they are chemically primed to take action," he says. The fight-or-flight response should be channeled in a positive way, though, such as moving money from a growth fund to a value fund after the market has tanked.

And if tinkering with your portfolio doesn't calm your nerves, maybe understanding a psychological quirk called recency will. It seems we pay too much attention to the recent past when making decisions. For instance, in 1999, the average investor thought the market would rise 30% in 2000, says Brian Bruce, editor of the Journal of Behavioral Finance. (Instead, the tech bubble burst and Standard & Poor's 500-stock index started a three-year plunge.)

Bruce says that recency can also make investors more pessimistic. Events such as the Korean War and the Cuban missile crisis, and bear markets, such as the ones that followed the 1987 market crash and the demise of the dot-coms, destroyed investor optimism. But in the year following the bottom of those setbacks, the S&P 500 rose 36.6%, on average.