This article originally published in The Northern Daily Leader on 6 August 2011.
They say there is a little bit of prison-camp guard in most of us. Not a pleasant thought, but that’s what Yale University psychologist Stanley Milgram discovered in a series of controversial experiments in the 1960’s. In the experiments, unwitting university students were instructed to give apparently painful electric shocks to another person (in reality an actor, privy to the full experiment) each time that person gave the wrong answer to a simple memory test. At each incorrect answer the voltage of the shock increased, to a point where it would apply a fatal shock of 450 volts. The students could hear the person scream when they were zapped, but could not see them – in fact the cries of pain were actually a series of tape recordings, as there was no actual shock applied – it was all an elaborate ruse to determine how far the students would go in applying ever more painful ‘shocks’ to the hapless person in the adjacent room. Somewhat worryingly, Milgram found that 65% of the students who participated in the experiment were willing to administer the final and fatal 450 volt shock, despite the obvious discomfort (to put it mildly) of the actor in the room next door.
You’re probably asking yourself what all this has to do with finance – well fortunately psychologists do more than simply terrorise students into thinking they’ve shocked someone to death; they also explore people’s behaviour when dealing with money and investments. And they have unearthed some surprising findings – for example, did you know that most people ‘feel’ a loss twice as keenly as they appreciate a gain of the same magnitude? So losing $5 makes you twice as upset as the happiness you gain from making $5, which seems fairly irrational! Psychologists also found that most of us suffer from ‘confirmation bias’, which means that we tend to favour information that confirms our views, regardless of whether the information is true or not. Another discovery is the ‘house-money’ effect, which found that people tend to gamble more recklessly with money from a windfall (such as a profitable investment or a winning scratchie). It’s no surprise why casinos are happy to give you free chips when you join their loyalty club. It turns out that investing behaviour is driven by our cognitive and emotional wiring, a lesson learned thanks to psychologists like Milgram and his tyrannical students!