Are You Logical? Answer These 5 Questions to Find Out

Do you make investment decisions based on sound logic, or are your choices emotionally driven?

While you may be able to answer that question based on your portfolio's performance, this simple five question quiz can also offer you some insights. If you understandi how you make investment decisions, you can

Question 1 - Which stock do you sell?
You have been given $10,000 and bought 100 shares of two different stocks at $50/share each. Over the next month, one stock moved down to $25/share while the other moved up to $75/share. If you have to sell one stock, which do you sell?

a. The $25/share stock

b. The $75/share stock

Note: Picture from JohnWinsor.com
Turn the page for the answer.

Sell the loser - (a) the $25 stock
Most people pick (b) and sell the $75 stock. That's because we tend to mentally anchor both stocks at the $50 purchase price. If we sell the $75 stock, we lock in our brilliant stock pick forever and have bragging rights of a 50% gain in only a month.

On the other hand, if well sell the $25 stock, we are locking in a stinging 50% loss without hope of recovering this loss.

But the above arguments are not economically sound. If you sell the winner, you recognize a $2,500 gain and have to pay about 30 percent, or $750 to the IRS. On the other hand, if you sell the loser, you recognize a $2,500 loss and reap the same $750 tax benefit, compliments of the IRS.

If you missed this one, don't feel too bad. I regularly teach CPAs, and 75% of them miss it as well.

Question 2: College Basketball and Investing
College basketball has lessons for investors. Take this one:

In college basketball, what percent of the time do you think the team behind at halftime wins the game?

a. 20 percent

b. 30 percent

c. 40 percent

d. 50 percent

Note: Photo from CollegeBaseketballOdds.org

College Basketball, the News, and Hollywood

The correct answer is (a) - 20 percent. And in case you're wondering - yes, I actually counted a whole season's worth of scores to get this statistic. A tedious task to be sure, though it did get me mentioned in a Jonathan Clements Wall Street Journal article.

People typically guess between 30 to 50 percent. Logic tells us that the same team that got behind in the first half is the same team that shows up in the second half. But we all know what makes headlines. Are you going to hear about the game where the team is behind by 10 at halftime and loses by 20, or the game where the team behind by 10 at halftime comes back to win in double overtime? You may have noticed that what makes news is not always a representative sample of life.

Further, have you ever seen a movie where the last place sports team finishes the season in last place? Me neither. And you know why that is? Because this is America and we love the underdog. This leads us to be far too optimistic in estimating the odds of a comeback.

You may be asking what this has to do with investing. Well open the newspaper and let me know how many Morningstar one star funds you see advertised? Turn on CNBC and count the number of managers touting their market underperformance. I think you'll get a zero.

The winning funds and managers make all of the noise, so they're a lot easier to notice. We also think the losers are few and far between, making us too optimistic in our abilities to find winners.

Question 3 - Three Cards in a Hat
There are three cards in a hat - one is red on both sides, one is green on both sides, and one is red on one side and green on the other. Without looking, you reach in and pick a card that is red on the side you are looking at. What is the probability the other side is red?

a. 66.7 percent

b. 50 percent

c. 33.3 percent

Note: Photo from ClipArtHeaven.com
Three cards - not as easy at it seems
The correct answer is (a) 66.7 percent, though most pick 50 percent. What is at play here is something called heuristics - mental shortcuts we take that lead us to make mistakes. We know you are not holding the green-green card and naturally think we have one of two cards left over. Our mental shortcuts lead us to believe that the odds are clearly 50 percent.

In reality we could be looking at one of three sides of a card that are red. Two will have the other side red while one will have the other side green.

Question 4 - Count the "F"s
If the three cards question was too difficult, spend 30 seconds doing a simple test - just count the number of F's in the statement below:

FINISHED FILES ARE THE RESULT OF YEARS OF SCIENTIFIC STUDY COMBINED WITH THE EXPERIENCE OF YEARS.
How many did you count?

a. 3

b. 4

c. 5

d. 6

F Counting
There are actually six F's so the answer is (d). Take a look at the statement again.

FINISHED FILES ARE THE RESULT OF YEARS OF SCIENTIFIC STUDY COMBINED WITH THE EXPERIENCE OF YEARS.

More heuristics here. We tend to skip the F's in the word "of." We can also make these same simple mistakes when it comes to investing.

Question 5: Certificate of Deposit Rates
Today, the highest CD rate I've come across is about 3 percent APY. In 1980, rates were as high as 12%. Which rates were better?

a. 3 percent APY Today

b. 12 percent APY in 1980

CD rates are much higher today
The correct answer is (a) - 3 percent APY today. If we earn 3 percent, we give a third to the IRS leaving us with 2 percent. Inflation is running at three percent so we are about 1 percent behind in real terms.

While the above scenario isn't good, in 1980 our 12% left about 8% after taxes. Inflation was running at 15% so the investor lost about 7% in real terms. Far worse than today.

We tend to think in nominal term rather than real inflation adjusted terms. It's real returns that matter, however.

So, how did you score? Click to the next page to interpret your score and see what missing some of these questions might mean to your investing.

If you scored 3 or more, you are either doing pretty well or you had seen some of these questions before. But more important than the score the investment lessons to be learned:

Question 1: If you sold the winner and kept the loser, you may be investing for emotional gain rather than maximizing your economic return.

Question 2: If you missed the college basketball odds, you are likely to miss the odds of investing. Over 25 years, an active investor has far less than a one percent chance of beating the passive portfolio.

Questions 3 and 4: Simple mental shortcuts lead us to make simple mistakes. In investing, the odds are you don't know the odds.

Question 5: Get real - quit thinking in nominal terms.

The first step to becoming a better investor is knowing that you have irrational tendencies and make simple mistakes. Only after we are aware can we question which part of our brain is at work.

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Allan Roth

Allan S. Roth is the founder of Wealth Logic, an hourly based financial planning and investment advisory firm that advises clients with portfolios ranging from $10,000 to over $50 million. The author of How a Second Grader Beats Wall Street, Roth teaches investments and behavioral finance at the University of Denver and is a frequent speaker. He is required by law to note that his columns are not meant as specific investment advice, since any advice of that sort would need to take into account such things as each reader's willingness and need to take risk. His columns will specifically avoid the foolishness of predicting the next hot stock or what the stock market will do next month.

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