New Year's Resolutions for Behavioral Investors

Wednesday, Jan 01 2014 by
18

Death or (um ... ) Death

Apparently the ancient Babylonians would, at the start of each year, promise to pay off their debts and return stuff that they’d borrowed, like the lawnmower (or, as we would refer to it, the neighbor’s goat). As we saw in On Incentives, Agency and Aqueducts  they had good reason to be cautious as the punishment for theft was death. Although, to be fair, the punishment for everything in Ancient Babylonia was death. What they lacked in imagination they made up for in consistency. These days we have less strict incentives to keep to our New Year Resolutions, but would probably find ourselves wealthier if we could stick to a few simple rules. The essence of being a psychologically aware investor is self-control, and what could be less modern and more ancient than that?

Uncertainty in a Modern World 

Generally people make two sorts of investing mistakes. Firstly we make mistakes of analysis: we’re busily forecasting in a world in which the future is at best shrouded in uncertainty. We can’t possibly get all decisions correct. Secondly we make psychological mistakes: our minds betray us into making decisions in which the balance of probable outcomes lies against us. And, to compound the issue, we usually ascribe the latter sort of mistake to the former sort of category: we blame the uncertainty of the world for the mistakes of our minds.

There are lots and lots of variants of behavioral bias – I keep The Big List of Behavioral Biases as an amusing aide memoir to the complexity and multiplicity of our ingrained inability to think straight, but there are a few simple things we can do to reduce our error rates and, ultimately, improve our returns. If the Babylonians could do it, I don’t see why we shouldn’t.

So, before we embark on and embrace another year of monetary mayhem, here are a few simple resolutions to guide us on our way:

I Will Not Sell Winners To Buy Losers

Our number one stupid behavior is selling winners to buy losers. This is one of the most famous pieces of research ever done in the area, by Brad Barber and Terrance Odean, and they showed that overwhelmingly the stocks that internet traders sold went on to outperform the ones they purchased to replace them, an outcome of overconfidence. This tendency to sell winners and buy losers is known as the disposition effect, but is a facet of loss aversion, our inability to sell at a loss.

The outcome of this is simple: we grimly hold onto to losers in the hope they’ll come good while we sell our winners to bank a guaranteed profit. “You never go wrong taking a profit” goes the old proverb. Well phooey to that. Winners should only be sold if they are significantly overpriced, otherwise a good stock is likely to keep on winning. 

I Will Track My Returns

It’s a remarkable fact that most investors don’t know whether they’re making money or not. In fact, when research has looked at how well people do during bull markets it turns out that they perform much, much less well than the markets – but they don’t know it. The main reason for this abject performance is that they trade away their profits by attempting to time the markets when they’d simply be better off riding them.

Unfortunately there’s no simple way of convincing you or anyone else of this – it can only be done through the simple expedient of keeping proper records. Of course, the people who need this most are the ones that think they need it least. This is an aspect of blind spot bias, the issue being that most of us will accept that other people are biased, but refuse to agree that we ourselves are. Well, phooey to that, too.

I Will Treat All Money As Equal

 Our hatred of taking a loss and our unwillingness to track our returns means that we play mental games with our money. To be precise we allocate different sorts of money to different sorts of mental accounts, and we then use these accounts to hide away losses. We looked at an example of this in Behavioral Portfolios where people have risky accounts and safe accounts and get all upset when safe investments turn out to be risky ones. It’s all the same pot of money; don’t treat different sets of investments or securities separately from others, because this opens you up to lots of nasty issues that we need to avoid. My particular favourite is when people partially sell some stock that’s done well in order to let the rest “run for free”, the idea being that if you end up losing it all it doesn’t matter because you’ve already covered your investment. This is the epitome of loose thinking, and the worst sort of mental accounting. Don’t do it.  Phooey, phooey, phooey.

I Will Not Listen To Fake Gods (or Experts)

 In an uncertain world such as that of investing there’s not really much prospect of anyone getting short-term forecasting right on a regular basis. Most experts are talking heads, and most forecasts are simply projections of the recent past – because actually projecting the recent past into the near future will be right most of the time. The trouble is that when it’s not right it’s not a bit wrong: it’s totally and utterly and disastrously wrong. If you’d rather accept the advice of third-parties rather than do your own heavy lifting then you really have no business investing for yourself. Investment “experts” are just as fallible as you and me because they’re operating in an environment characterized by uncertainty. Unfortunately humans are particularly attracted to people who express opinions with great confidence and utterly useless at checking whether those opinions turned out to correct. Make your own mistakes, just make sure you recognize them when you do: that way at least you get the benefit of learning from them.

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I Will Not Fall Victim To Temptation 

We are all, to some extent, hobbled by our inability to stick to our resolutions. Real life keeps getting in the way. We have busy lives, comprised of lots of moving parts, which make it difficult for us to be consistent. In the short-term the most likely reason we will fail to keep our promises to ourselves is emotion – and for this reason we need to try and avoid making investing decisions when in a tired or emotional state. Many of the most experienced professional investors avoid investing during periods of great market uncertainty, partly because they can’t make any kind of prediction, and partly because it’s difficult to separate the market turmoil from their mental states. 

In the longer-term, however, this is down to you. If you can’t demonstrate self-control, if you can't resist that tempting treat, can’t help flashing the credit card to get that glitzy gizmo and would rather buy now and pay later you’re unlikely to be able to demonstrate the discipline needed to overcome issues of behavioral investing bias. Fortunately you’ll probably never know it, and the rest of us can get on with making money out of your misfortune. Ho hum.

But There Is More To Life Than Money

 Finally, though, remember that money does not make us happy. What we do with money can make us happy, especially if we buy ourselves and our loved ones experiences. A new possession gives us a temporary lift but a joint experience is something that can be relived time and time again, and usually grows in the retelling.

Investing is a means to end. Just make sure you understand both the means and the end. Oh, and now might be a good time to return the neighbor's lawnmower.

I hope you all had a successful and happy 2013, and wish you a better 2014.

Tim

   

 


Filed Under: Behavioural Investing,

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As per our Terms of Use, Stockopedia is a financial news & data site, discussion forum and content aggregator. Our site should be used for educational & informational purposes only. We do not provide investment advice, recommendations or views as to whether an investment or strategy is suited to the investment needs of a specific individual. You should make your own decisions and seek independent professional advice before doing so. The author may own shares in any companies discussed, all opinions are his/her own & are general/impersonal. Remember: Shares can go down as well as up. Past performance is not a guide to future performance & investors may not get back the amount invested.


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9 Comments on this Article show/hide all

DJLJ23 2nd Jan 1 of 9

Hi Tim,
Many thanks for a set of timely reminders, the only one of which I disagree with is "Running for free", thou I'm not sure that my rational is the same.
I'll often top slice my winners where
a) I have doubts about aspects of the company, but momementum/news flow keeps it going up
b) My portfolio is too dependent on that share
c) The share is extremely volatile, but I the potential for a large re-rating exists
and yes I do sometimes classify these as running for free, that does not mean I discount sensible management of the share, but does mean I might have a more tolerant approach to stop losses.
thanks again

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Katewarren 6th Jan 2 of 9
2

I think it is probably true Tim that " no one ever went broke taking a profit." Funny how there are always two totally opposing views to statements like this. " don't be greedy." Is another. Personally, there have been many times in the past when I didn't take a good profit......hoping for more. Guess what ? They turned into losses !
I take my good profits now, or " top slice ." And I am much happier and my portfolio is healthier. Sometimes the shares I have sold go higher and sometimes they don't and it was a good call. Instinct ! But, I ( and perhaps many other readers out there ) would love to know the formula / metric ( or whatever you might call it ) for actually knowing when a share is significantly overpriced or just overpriced. Good investing is an on going learning experience and for many of us , a lonely one, with no one to ask for advice. I would greatly appreciate it if you would share your knowledge on this point. Many thanks for the article.


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emptyend 7th Jan 3 of 9
2

I can recognise most of the above faults. But the one that resonates with me most is the caution about not listening to "experts".

As some people know, I have been running one particular winner ( SOCO International (LON:SIA) ) for nearly 15 years now. I have prudentially top-sliced a couple of times but I remain massively overweight and, though it certainly hasn't "outperformed" over the last 5 years (taken as a whole), a gain of 40% puts it top quartile in the sector, even if ex-post it is clear to see that more than half the FTSE350 has doubled or better. That indicates (rather to my surprise) a bad sector choice rather than anything particularly stock-specific.

I'm entirely happy with my actions in holding - though that is doubtless conditioned by the fact that doing nothing has yielded c. 58x my initial purchase price ....and anyone who bought five years ago might be feeling a bit underwhelmed and wish they had gone for racier growth stocks or classical recovery plays, such as builders.

But the reason I alight on the "experts" point is that some "experts" remained resolute sellers of SOCO International (LON:SIA) from the start of those 15 years until the point when they lost their jobs. And many "experts" (such as Goldman Sachs, who recently changed their view and afforded the Chairman an unexpected buying opportunity) would apparently be sellers today.

Rightly or wrongly, I consider myself an expert in this particular stock - which is why no-one should listen to me :-) However, many here and elsewhere are familiar with my reasons for continuing to hold - and we should find out in the next few months whether those reasons prove well-founded or not.

So....from my own experience.....I would add a further type of "error".... which is to place excessive over-reliance on timeframes of events occurring when these events are in large part beyond management control. Many people who have read my comments over recent years will be aware that I have often indicated that a particular outcome could happen "at any time". And it could have done....and still could. But it is a big leap from that to assuming that it WILL happen in the next 1/2/6 months, when the timing is largely dictated by third-party actions.....and it is a mistake to position oneself on the assumption that such an event will occur.

Ultimately I'm as vulnerable to the punters' errors as anyone else - and I've had my share of losing longshots. But I also have faith in stocks which are businesses which can be analysed with some accuracy - especially when they have robust financing and balance sheet.

So perhaps one should distinguish between investments and punts? A punt is anything that hasn't been personally researched in considerable detail......and so, for most people most of the time, all their shareholdings are actually "punts" and should be assessed in the context of the caution above:

Most experts are talking heads, and most forecasts are simply projections of the recent past – because actually projecting the recent past into the near future will be right most of the time. The trouble is that when it’s not right it’s not a bit wrong: it’s totally and utterly and disastrously wrong. If you’d rather accept the advice of third-parties rather than do your own heavy lifting then you really have no business investing for yourself. Investment “experts” are just as fallible as you and me because they’re operating in an environment characterized by uncertainty. Unfortunately humans are particularly attracted to people who express opinions with great confidence and utterly useless at checking whether those opinions turned out to correct. Make your own mistakes, just make sure you recognize them when you do: that way at least you get the benefit of learning from them.
Basically investing for oneself is a game of playing the odds. The odds are that (in the vast majority of circumstances) you will know no more than the next man - and so, when the market presents you with "buying opportunities" or "selling opportunities" then they should always be seriously considered..... even if you are confident that you know more than others. The important behavioural point here, I'd suggest, is that you should be biased towards taking the opportunity that the market presents unless you are completely happy to live with the consequences of being wrong.
 
When the proverbial brown stuff started hitting the fan in the financial crisis, I got out of equity markets in general - but I thought carefully about a few specific stocks and decided to hold on. This proved to be a longer and bumpier ride than I had expected - but I have no regrets, and would do the same again. And it hasn't worked out too badly, so far at least, even though (in the estimation of some people) I was "wrong".
 
ee
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timarr 7th Jan 4 of 9
3

In terms of selling I think the broad point is that selling solely because a share has gone up in price is always an error, and that's true regardless of whether it's a partial sale or a full one. There are, of course, valid reasons for selling that can be linked to a rise in price - the share has reached a valuation level where it's plainly overvalued or the position size has become so large as to overwhelm portfolio diversification rules, or whatever.

Unfortunately the evidence suggests that people often do sell simply because the share has gone up in price. This seems to happen for a variety of reasons - loss aversion (because selling a winner means you can never lose, and this is often the reason for top-slicing), or because the investor has seen another share they fancy more (most internet traders lose by selling, because their sales outperform their purchases) or simply because they don't really know why the share has gone up in price and are fearful it will fall back down, a sort of animistic belief in mean-reversion. And often it's a combination of these factors.

In general, though, momentum effects can continue for far longer than you might expect - 2 to 3 years in general - so that a share that's rising will often continue to rise. And that's ignoring the shares that have a natural barrier to entry for competition and which will continue to generate rising earnings forever and a day. It seems to be the case that more experienced investors have learned this the hard way - they trade less often and run their winners for longer (and they're more diversified, although that's another story).

So, in general, running winners and cutting losers is the best approach.  But I'm afraid that''s only true within the context of actually knowing what you're doing when you analyze shares ... 

timarr

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Ramridge 8th Jan 5 of 9
3

Hi Tim
This is an excellent article and well argued thoughts.
A basic issue that I am constantly grappling with is that the mental model that we have of the world is different to the reality out there. The greater the delta the more mistakes we make because our judgement is based on a flawed mental model.  That we are hard-wired to be optimistic simply accentuates the gap.


Say you have made a decision to buy a stock. In coming up to this decision, you have evaluated a number of factors, hard and soft, rational and irrational, fuzzy and binary.Three months later the stock has tanked and looking back you swear and say 'how could I have been so dumb'.
To mitigate against this (you cannot totally eliminate the risks) I now have a checklist consisting of hard and soft criteria which I run against each potential candidate stock. That has quite a few advantages. it stops me from making knee jerk investments. A stock that looked a bargain suddenly does not look so good after putting it through the wringer. I have a continuous feedback loop and review the criteria and weights after the events. I am loath to call this a system; it is more of a discipline. But in the end we are all hostages to the black swans and the 'unkown/ unkown's.
All the best for 2014 to all. Ram

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cig 8th Jan 6 of 9

In reply to timarr, post #4

"most internet traders lose by selling, because their sales outperform their purchases"

Any evidence on that one? This just doesn't ring right (as in retail sales/purchases data is mostly white noise). I can imagine someone saw this effect as a fluke in a single data set and published a weak paper on it, but I doubt it can be reliably reproduced.

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timarr 9th Jan 7 of 9
2

Hi Ram - yep, a basic checklist is an excellent defence against kneejerk actions. Generally avoiding making investment decisions in a hurry is probably the single best advice you can get, but people who are short-term trading will obviously find that hard to do. But of course you can get a good result from a poor piece of judgement and vice versa, the world of investment is ruled by uncertainty. It's part of the fun, to be honest.

Hi Cig - the main paper is famous, and justly so, it's by Terrance Odean, "Do Investors Trade Too Much?". It's part of a series, probably my favourite is Odean and Barber: Online Investors: Do The Slow Die First? That one shows that when people switched to online trading they promptly started overtrading. The underlying theme is that people are overconfident about their ability to predict the future. In yet another study, Trading is Hazardous to Your Wealth, they showed that households that traded more underperformed the market by 6.5% and underperformed less active traders by a similar amount. All of these studies have seriously large sample sets.

You're correct, of course, that this isn't distinguishable at the level of market data because, of course, this is not all traders, and the effect is distributed over lots of stocks, such that the signal is lost in the general noise - i.e. we can't trade on this effect but we can be, as individuals, affected by it.

timarr

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cig 9th Jan 8 of 9

In reply to timarr, post #7

I wasn't questioning that people trade too much -- no doubt here! -- just the claim that there is negative alpha in the trades ("sales outperform purchases"). I expect virtually all the loss to overtrading to be attributable to trading costs (commission + spreads + tax if applicable), rather than bad trades as such.

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Ramridge 10th Jan 9 of 9
1

Thanks, Tim. Yes the investment world is a complex dynamic system which does not obey Newtonian laws. Who knows, the proverbial butterfly may already have fluttered its wings in China while I am tinkering with re balancing my portfolio. :-)

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About timarr

I'm a UK based technologist (career) and psychologist (academic) with a long-term interest in financial markets, with a particular emphasis (and skill) in how to not make money out of them. When I'm not working or blogging I'm to be found childminding, walking the dog or hiding in the garden shed with a good book :) more »


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