This is part 2 of a series on getting to "Know Thyself" inspired by the "Van Knapp Pyramid of success for dividend growth investing". You can find Part 1 here.
In this part, I will cover the theories that try to explain why individual investors tend to sell winners and hold losers, as well as some concepts that influence our decision-making process. I will also present some questions I believe you need to answer to properly "Know Thyself".
Selling winners and holding losers
Individual investors have a tendency to sell winners and hold losers. This effect has been labeled the "disposition effect". The effect is present for both individual and institutional investors, but to a much higher degree for individual investors.
"An investor's chief problem, even his worst enemy, is likely to be himself."
- Benjamin Graham
What is the explanation for this effect, and what can we do to prevent losing money because of it? Several theoretical models try to explain the psychological processes that create the effect. Loss aversion, prospect theory and cognitive dissonance are the most widely recognized.
Loss aversion leads us to hold on to losers to avoid realizing losses, and at the same time, sell winners early to avoid the pain of losing a profit instead of letting the winners run. The rationale behind this is the difference in joy and pain experienced from realizing a profit versus realizing a loss. A 100-dollar loss triggers more pain compared to the joy triggered by a 100-dollar profit. Many studies suggest that losses are twice as powerful, psychologically, compared to gains. To balance a 50-dollar loss psychologically, you would need to realize a 100-dollar profit.
"Prospect theory, which was developed by Kahneman and Tversky (1979), is one of the most often quoted and best-documented phenomena in economic psychology. The theory states that we have an irrational tendency to be less willing to gamble with profits than with losses."
- Tvede (1999)
The prospect theory tries to explain our choices when facing probabilistic alternatives that involve risk. We tend to be risk-averse when facing high-probability gains (95% chance of winning 10.000 dollars versus 100% chance of winning 9.450 dollars), even if the final outcome is unfavorable. At the same time, we are risk-seeking when asked to choose between high-probability losses (95% chance to lose 10.000 dollars versus 100% chance to lose 9.450 dollars), even if the final outcome again is unfavorable. When facing low-probability alternatives, the roles are reversed. We tend to be risk-seeking when facing low-probability gains (5% chance to win 10.000 dollars versus 100% chance to win 550 dollars) and risk-averse when facing low-probability losses (5% chance of losing 10.000 dollars versus 100% chance of losing 550 dollars), even if the final outcomes are unfavorable.
95% chance to win $10,000 vs. 100% chance to win $9,450.
Fear of disappointment.
95% chance to lose $10,000 vs. 100% chance to lose $9,450.
Hope to avoid loss
5% chance to win $10,000 vs. 100% chance to win $550. Hope of large gain.
5% chance to lose $10,000 vs. 100% chance to lose $550
Fear of large loss.
(From Tversky and Kahneman, 1992)
Cognitive dissonance is the psychological effect of a mismatch between expectations and reality. It arises when we process new information that collides with our established view. In such an event, action and cognition might be dissonant. We realize cognitively that something has changed that should influence our actions, but established patterns cause us to act based on previous experience or knowledge. A process labeled dissonance reduction takes place to bring cognition and actions in line. An example of such an event can be receiving a disastrous profit warning for a stock you have owned for a long time and have had a firm belief in for the future. There are four ways of dissonance reduction:
- Change behavior or cognition (Accept the changing fundamentals and sell the stock.)
- Justify behavior or cognition by changing the conflicting cognition ("The profit warning was not so bad, and there were bright spots in the presentation. I will hold the stock.")
- Justify behavior or cognition by adding new cognitions ("The stocks' future prospects probably have increased due to the beneficial changes that caused a drop in earnings temporarily. I will hold the stock or add to it on the dip.")
- Ignore or deny any information that conflict with existing beliefs ("The profit warning will not affect the price of the stock due to the strong qualities of the company.")
"Sometimes people hold a core belief that is very strong. When they are presented with evidence that works against that belief, the new evidence cannot be accepted. It would create a feeling that is extremely uncomfortable, called cognitive dissonance. And because it is so important to protect the core belief, they will rationalize, ignore and even deny anything that doesn't fit in with the core belief."
- Frantz Fanon, Black Skin, White Masks
In all aspects of life, we tend to repeat behavior that we connect with rewards or pleasure and avoid behavior that we connect with pain. For individual investors, this tends to lead to investing in stocks where we have previously realized profit and avoiding stocks we where we have realized losses. This can also apply to whole sectors or industries. This is an important factor to have in mind when researching investment options.
Anchoring is the tendency to rely on the first piece of information we receive when making decisions. In finance, this could be the tendency to judge price action in relation to the price the stock traded at the first time we researched it. If you found a stock you want to buy that traded at $50, you would have a tendency of judging any price over $50 as a premium and under $50 as a discount, regardless of the fundamental facts of the stock. You might have told yourself that you would buy the stock when it reaches $45. We all love to get a good bargain, even if your "bargain" price does not reflect the real value of the stock. Another anchoring effect would be to compare the price to recent highs or lows. When anchoring at the lows, we would have a tendency to consider the price of the stock as high and delay purchase while waiting for the price to drop. When anchoring at the high, we would consider the stock as cheap and buy with the anticipation of the stock reaching that high again. Both of these examples show how the anchoring effect can decouple fundamental valuation from psychological valuation.
If we are aware of these psychological effects, we can minimize the losses due to them. They often correlate with what we experience as gut feeling. When we realize this, we can stop listening to our gut feeling and start making rational decisions based on sound judgment. The most important parts are to be dynamic in our beliefs, so we can adjust our investment thesis according to new information, and to not make irrational decisions based on gut feeling.
Get to "Know Thyself"
I have made a list of questions I have asked myself during this "get to know myself" exercise. Hopefully, it can help you to get to know yourself a bit better as well. I am sure there are many good questions I should consider that I have left out. I will be grateful for any suggestions in the comment thread.
How much time do I want to spend on my investments?
The answer to this question impacts almost every part of the rest of the self-analysis. With more time to spend, I can allocate more time to better myself on any shortcomings realized through this process. It is also vital for the next steps of the pyramid, which are to set my goal and objectives and to develop plans and strategies. The ambition level of the plan I sketch out will need to harmonize with the time I plan to spend on maintaining the investment account. I am currently spending too much time in front of a computer or with my head in a book to better understand how I should approach long-term investing. This is a temporary situation - I plan to spend less time as soon as my plan is ready and I have rebalanced my portfolios according to the plan. The time spent on maintaining my positions should be minimal. I want to spend as much time as possible with my family when I am not at work.
What are my areas of expertise, and what is the current level of my skills and knowledge?
To set realistic goals and objectives, I need to know where I am now. The goals and strategies should include both the goals and the objectives for my investments and for me as an investor, starting with the present situation and going forward.
"Invest in yourself. Your career is the engine of your wealth."
- Paul Clitheroe
Spending time gaining knowledge and skills is connected with question number 1. I need to balance the time I spend on becoming a better investor with the time I spend on improving other parts of my life. In the accumulation phase, generating income is important to be able to save and invest more. Investing time in my career might, at this point, be a better choice than spending it learning about finance.
Am I willing to cut expenses to be able to save and invest more?
A frugal lifestyle is recommended to be able to save and invest more now and reap the benefits later. I do recognize the importance of starting early and saving as much as I can, for as long as I can. The power of compounding is astonishing. But I also want to live today - I want to take the kids on holidays and buy them, the wife and myself things we want. But I will think twice on every expense and weigh the present reward of the expense against the potential future reward. I will have to quote Warren Buffett to defend my views on this:
"It's nice to have a lot of money, but you know, you don't want to keep it around forever. I prefer buying things. Otherwise, it's a little like saving sex for your old age."
How does my own judgment influence my investments, and how much risk am I willing to take?
I have briefly outlined the psychological traits of individual investors in this article. I guess I am above-average overconfident and prone to over-trading. I also recognize many of the traits described by the loss-aversion theory, the prospect theory and the cognitive dissonance theory. In my derivatives trading, I realized this many years ago and developed mechanical trading systems that eliminated my judgment from the trading process. This turned loss into profit. I will have to carefully consider the degree of judgment I will trust myself with in my investment plan. As a young investor, I can afford to accept more risk than an older investor. I am willing to be fully invested in equities and accept the risk that it involves, because I expect equities to outperform other asset classes over time. I do need to be aware of the dangers of loss aversion and the tendency to sell winners and hold losers.
What is the time frame for my investments?
I want to answer this with "forever", but life happens. It is impossible to predict events that will have an effect on my income, and thus, my savings ability. But my plan is to gradually build a portfolio that will supply additional income in our retirement. Until then, I plan to only contribute money to the account and make no withdrawals.
Through the process of writing these articles, I have made several important realizations that will have an effect on how I proceed with my investments. I found the exercise very useful, and hope you have had some benefits of reading my reflections. Maybe they can inspire you to getting to know yourself a little better. But as Van Knapp stated in his article, it is a process that needs to be repeated as you change over time. As Gen Xers, we are just approaching mid-life. Significant changes have taken place in our lives during the last decades. Most of us have gone from being single to being in a relationship, with children. As we progress in our careers, more responsibility follows. And our psychological traits change as we age as well. A "Know Thyself" process now will be extremely beneficial for Gen Xers as we start to dream about or dread retirement. The investments we make now can be the determining factor for how our financial situation during retirement will be. To ensure that we get the maximum benefit of our investments, we should optimize every factor that will influence decision-making, and in turn, our returns. There is no doubt that our judgment is one of those important factors.
The many concepts covered by these two articles were only briefly summarized, but just to be aware of the effects of these concepts might help us as individual investors to make better decisions. If you really want to understand how these concepts affect your investments and trading, you should allocate some time to further study behavioral finance. A good place to start would be with Odean and Barbers' review article mentioned at the beginning of part 1. There are several good sources on the internet as well that are easier reads. You could start out by reading through the articles about behavioral finance on Investopedia.com. They also give some advice on how to minimize the effect of behavior on your investments.
The next phase of creating my investment plan would be to set goals and objectives, and develop a plan and strategy. For the latter part, the insights gained from understanding how my behavior influences my investing approach is invaluable. I will need to develop a plan and strategy that fully acknowledges that I can trust my own judgment only to a very limited degree in the decision-making process.
Comments are, as always, most welcome. Valuable learning comes from the discussions following these articles, and I am always keen on learning new things about the topics I write about. I am not an expert on this field. I simply read, process, and share my reflections with you. Please help out to improve the collective understanding of these concepts.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.