Just before we went to press, the Supreme Court ruled on the 401(k) case Tibble v. Edison. This was a closely watched case among those in the financial and employee benefits community because it focused on whether or not an employer can be held accountable for not offering the lowest-cost share class available for a given fund in its 401(k) plan. As you can read here, in a unanimous decision the court said that trust law applies and the employers must act with a standard of prudence when carrying out their fiduciary duties. Furthermore, the statute of limitations for when an employee can sue over alleged breach of this responsibility starts when a breach is not corrected—as opposed to being limited to when it first occurs.

I mention this case because in order to provide a summary of the ruling, I had to refrain from discussing a recent study in this month’s Briefly Noted section. The specific study looked at investor regret. Including a summary of it would have been somewhat apropos given this month’s feature article on asset bubbles.

Regret and asset bubbles might not seem like two things that belong side by side—unless of course we’re talking about Sir Isaac Newton’s experience with the South Sea bubble—but there is a relation. And MRI machines belong in the discussion too.

A documented behavior is for investors to sell investments that have appreciated since purchase and hold on to investments that have decreased in price since purchase. This is referred to as the “disposition effect.”

Another documented behavior involves purchase decisions. When an investor sells an investment at a profit and the investment continues to appreciate in value, the same investor is less likely to repurchase the investment. This pattern of behavior is known as the “repurchase effect.”

What’s interesting about the disposition effect and the repurchase effect is that they both trigger activity in the same part of the brain, the ventral Striatum (vSt). The vSt is located near the center of the brain. Researchers determined this by using MRI machines to monitor neural activity while study participants engaged in simulated trading of stocks. Notably, the same region of the brain has also been found to be important for reward processing.

The study’s authors, Cary Frydman and Colin Camerer, think there may be a single psychological mechanism influencing how regret influences trading decisions. (You can read their findings at SSRN.com; the study is entitled “Neural Evidence of Regret and its Implications for Investor Behavior.”) They acknowledge the influence of other factors on regret, such as social forces. In discussing other influences, Frydman and Camerer referenced a study published by Robert Shiller.

Shiller observed that regret can be created by observing others making money in the financial markets. An investor who is not invested, but sees others profiting from their investments, will regret not being in the market. As a result, the investor will feel an urge to get in, much like Isaac Newton did with shares of South Sea Company. Newton initially bought and sold shares at a profit, only to get back in late in the bubble after seeing friends get rich. It was an ill-fated decision and he lost a significant amount of money.

Part of Newton’s behavior may have also been related to stories. As Shiller explains starting here, bubbles are fueled by stories. A rationale for why asset prices are moving in a particular direction is commonly sought by investors and provided by the financial media. The stories provide insight into events that are often random or at least very difficult to predict. Stories also confirm a person’s belief about why prices should continue to go higher (or, in the case of a negative bubble, go lower.)

While stories can alleviate the uncertainties of asset price movement, stories can also lull investors into behaviors that may not be in their best long-term financial interest. As such, it is helpful to periodically stop and consider the true rationale behind your investment decisions.

Wishing you prosperity,

Charles Rotblut, CFA
Editor, AAII Journal
@CharlesRAAII