Your paper reports that well-performing funds do not advertise their good relative return, i.e. how well they performed compared to the market average. Do you know the reason for such a behavior? (Anupam Tyagi, India)

What we find is that firms report returns based on absolute performance. So if you have poor returns but which are good in relative terms, you will not report them. I suspect this happens because individuals key in on absolute returns, something that has been found in other contexts as well.

What tools do you suggest for a financial adviser looking to gauge a new client's risk tolerance and investment horizon? For instance, I have a new very wealthy client who said he wanted aggressive equities and to be invested right away, and that he would judge our performance over the next six months (...) We invested on May 8 (almost exactly the peak of the market) and he's already nervous. (Shawn McFarlane, CFA, St. Paul, MN, USA)

There is a large psychological literature that shows that people are bad predictors of their own preferences. While there is no specific tool that I know of which systematically predicts preferences, this is one area where the past may be a predictor of future performance. Understanding how a client has responded to variance in his or her portfolio in the past can be a good guide. Absent that, going through various scenarios with them (e.g., the fund drops 5%) might be helpful. One final thing that can be helpful (as Benartzi and Thaler have argued) is if you can get your client to look at his portfolio less frequently.

Does Daniel Gilbert's work on affective forecasting apply to investors? (Bob Zdanky, Noblesville, IN, USA)

Most of investments are about choosing between different assets whereas Gilbert’s work is about adaptation to a new state. While there surely are applications, it is not immediately clear how one would apply it.

Do you think investing performance gets negatively affected by the inherent emotions involved in decision making? Is passive investing based on quantitative models, which is devoid of human emotions and psychology, the answer to this? (Shinod E. S, Bombay, India)

Much of the work in psychology has pushed towards quantitative reasoning as a way to offset the psychological biases we suffer from. Even in areas such as medicine, expert systems (combined with human recognition of symptoms) have shown to be better than judgment by people. So, I’d go further. It’s not just that emotions negatively affect decision making. It’s also that cognitively we’re limited. Statistical analysis can greatly help us for a variety of reasons.

Your paper suggests that economic conditions affect the content of financial advertising. Does it also affect the way content is communicated to potential clients? Can we as investors become aware of this and protect us from manipulative advertising? (Lisa Droste, The Netherlands)

We definitely see the content of ads changing over time. For example, ads during the bubble emphasized growth messages while ads during the crash emphasized messages of expertise. I view this less as “manipulative” advertising than as messages catered to what individuals already believe to be true (i.e. fear during the bust). The ads are less likely to be creating those beliefs than simply catering to them.

Do you expect psychology to become incorporated into existing models of financial choices or to lead to new models?

I think it is too early to tell. I would hope to see a period of experimentation with different models during which the best candidates can rise to the top.

You claim that psychology matters for individual financial decisions. But advertisers can exploit the effects of psychological traits only if these can be somewhat predicted. Can they? (Edward Ballard, Phoenix, AZ, USA)

While understanding individuals’ psychology can be difficult, I do think that firms have been able to get some glimpses into it so as to affect their advertising.

Are more educated and informed investors more rational decision-makers, less influenced by advertising and psychological reactions to market trends? To put it differently, what is the relationship between ignorance and irrationality? (Carlos Nunez)

This is one of the most widely held beliefs for which there has been little or no supporting data. While it is an intriguing hypothesis, I think it is little more than that currently. In fact, there’s some evidence that more informed investors may do worse, not better since the extra information may generate over-confidence.

In his recent interview with SmartEconomist.com, your colleague Prof. Veronesi took the view that the Nasdaq bubble of the late 1990s was not a real bubble, but the result of rational behavior under conditions of extreme uncertainty. Do you agree with his view?

I don’t agree with this view. While a bubble is hard to define, I think there’s a basic sense in which there was money to be had in expectation. I don’t think we just had one “unlucky” draw about the technology underlying the bubble.