Behavioural Traps (2)

Behavioural Traps (2)

(The investing story of Dave, Jennifer and the investment counselor)

Psychological factors can thwart rational analysis and prevent investors from achieving the best results for their portfolio. Let's explore these behavioural traps through Dave, his wife Jennifer and his investment counselor IC.

The Technology Boom, 1999 -2001

TIME: October 1999

Dave: Jen, I've made some important investment decisions. Our portfolio contains nothing but these old fogy stocks like Philip Morris, Procter & Gamble, and Exxon. These stocks just aren't doing anything right now. My friends Bob and Paul at work have been making a fortune in Internet stocks. I talked with my broker, Allan, about the prospects of these stocks. He said the experts think it is the wave of the future. I'm selling a lot of my stocks and I am getting into the Internet stocks like Amazon, Yahoo!, Inktomi, and others.

Jennifer: I've heard that those stocks are very speculative. Are you sure you know what you're doing?

Dave: They had their time, but we should be investing for the future. I know these Internet stocks are volatile, and I'll watch them carefully so we won't lose money. Trust me. I think we're finally on the right track.


Fads, Social Dynamics, and Stock Bubbles
[IC: When everyone is excited about the market, you should be extremely cautious. Stock prices are based not just on economic values but also on psychological factors that influence the mood of the market. Fad and social dynamics play a large role in the determination of asset prices. Stock prices have been far too volatile to be explained by fluctuations in economic factors such as dividends or earnings. Much of the extra volatility can be explained by fads and fashions that have a great impact on investor decisions.]

[IC: Note how others influenced your decision, against your better judgment. Psychologist have long know how hard it is to remain separate from a crowd. It was not social pressure that led the subjects to act against their own best judgment but rather their disbelief that a large group of people could be wrong.]

[IC: The Internet and technology bubble is a perfect example of social pressures influencing stock prices. The conversations around the office, the newspaper headlines, the analysts' predictions - they all fed the craze to invest in these stock. Psychologists call this penchant to follow the crowd the HERDING INSTINCT, the tendency of individuals to adapt their thinking to the prevailing opinion.]

[IC: "We find that whole communities suddenly fix their minds upon one subject, and go mad in its pursuit; that millions of people become simultaneously impressed with one delusion and run after it... Sober nations have all at once become desperte gamblers, and risked most their existence upon the turn of a piece of paper... Men, it has been well said, think in herds... they go mad in herds, while they only recover their senses slowly and one by one." This happens again and again through history. Dave was convinced that "this time is different." The propensity of investors to follow the crowd is a permanent fixture of financial history. And following the crowd is not always irrational, although it may lead to some very bad results. Individuals have a feeling that "someone knows something" and that they shouldn't miss out. Sometimes that's right, but very often that is wrong. Economists call this decision-making process an INFORMATION CASCADE.]

TIME: March 2000

Dave: We are up 60% since October. The Nasdaq crossed 5,000 and no one I heard believes it will stop there. The excitement about the market is spreading and it has become the topic of conversation around the office.

Jen: You seem to be trading in and out of stocks a lot more than you did before. I can't follow what we own!

Dave: Information is hitting the market faster and faster. I have to continuously adjust our portfolio. Commissions are so cheap now that it pays to trade on any news affecting stocks. Trust me. We are up 60% in the last 6 months.

TIME: July 2000

Jen: Dave, look at our broker's statement. We don't hold those Internet stocks any more. Now we own Cisco, EMC, Oracle, Sun Microsystems, Nortel Networks, and JDS Uniphase. I don't know what any of these companies do. Do you?

Dave: When the Internet stocks crashed in April, I sold right before we lost all our gains. Unfortunately, we didn't make much on those stocks, but we didn't lose either.

I think we're on the right track now. Those Internet companies weren't making any money. All the new firms we now own form the backbone of the Internet and all are profitable. Most of the Internet companies are going to fall, but those supplying the backbone of the Internet - the routers, software, and fiber-optic cables - will be big winners.

Jen: But I think I heard some economist say that they are way overpriced now; they're selling for hundreds of times earnings.

Dave: Yes, but look at their growth over the last 5 years - no one has ever seen this before. The economy is changing, and many of the traditional yardsticks of valuation don't apply. Trust me; I'll monitor these stocks. I got us out of those Internet stocks in time, didn't I? Don't worry.

Excessive Trading, Overconfidence and the Representative Bias
[IC: From examining your trading records, I see that you were an extremely active trader. Let me tell you something. Trading does nothing for you but cause extra anxiety and losses. A couple of economists examined the records of tens of thousands of traders, and they showed that the returns of the heaviest traders were 7.1% below those who traded infrequently.]

[IC: It is extraordinarily difficult to be a successful trader. Even bright people who devote their entire energies to trading stocks rarely make superior returns. The problem is that most people are simply OVERCONFIDENT in their own abilities. To put it another way, research has confirmed that the averge individual - be he or she a student, a trader, a driver, or whatever - believes that he or she is better than average, which of course is statistically impossible.}

[IC: What causes this overconfidence? Overconfidence comes from several sources.
First, there is what we call a SELF-ATTRIBUTION BIAS that causes one to take credit for a favourable turn of events when credit is not due. Remember in March 2000 bragging to your wife about how smart you were to have bought those Internet stocks? Your early success fed your overconfidence. You and your friends attributed your stock gains to skillful investing, even though those outcomes were frequently the result of chance.
Another source of overconfidence comes from the tendency to see too many parallels between events that seem the same but are remarkably different. This is called the REPRESENTATIVE BIAS. This bias actually arises because of the human learning process. When we see something that looks familiar, we form a representative heuristic to help us learn. However, the parallels we see are often not valid, and our conclusions are misguided.

[IC: You mentioned your investment newsletters say that every time that such and such an event occurred in the past, the market has moved in a certain direction, implying that it is bound to do so again, but when you try to use that advice, it never works. This is finding patterns in the data when in fact there are none. Searching past data for patterns is called DATA MINING, and it is easier than ever to do with inexpensive computer programs. Throw in a load of variables to explain stock price movements, and you are sure to find some spectacular fits.
Psychologically, human beings are not designed to accept all the randomness that is out there. It is very discomforting for many to learn that most movements in the market are random and do not have any identifiable cause or reason. Individuals possess this deep psychological need to know WHY something happens. This is where the reporters and so-called experts come in. They are more than happy to fill the holes in our knowledge with explanations that are wrong more often than not.]

[IC: Before you bought the technology stocks in July of 2000, your broker compared these companies to the suppliers providing the gear for the gold rushers of the 1850s. It seemed like an insightful comparison at the time, but in fact the situations were very different. This is an obvious representative bias. It is interesting that you mentioned your broker, who is supposed to be the expert, is subject to the same overconfidence that you are. There is actually evidence that experts are even more subject to overconfidence than the layperson. These so called experts have been trained to analyze the world in a particular way, and selling their advice depends on finding supporting, not contradictory evidence.
Recall the failure of the analysts to change their earnings forecasts of the technology sector despite being bombarded with bad news that suggested that something was seriously wrong with their view of the whole industry. After being fed great news by the corporations for years, supported by 20 to 30 % earnings growth rates, they had no idea how to handle downbeat news, so most just ignored it.
The propensity to shut out bad news was even more pronounced among analysts in the Internet sector. Many were so convinced that these stocks were the wave of the future that despite the flood of ghastly news, many only downgraded these stocks AFTER they had fallen 80 or 90%!
The predisposition to disregard news that does not correspond to your worldview arises from what psychologists called COGNITIVE DISSONANCE. Cognitive dissonance is the discomfort we encounter when we confront evidence that conflicts with our view or suggests that our abilities or actions are not as good as we thought. We all display a natural tendency to minimise this discomfort, which makes it difficult for us to recognize our overconfidence.]

TIME: November 2000

Dave (to himself): What should I do? The last few months have been dreadful. I'm down about 20%. Just over 2 months ago, Nortel was over 80. Now it is around 40. Sun Microsystems was 65, and now it is around 40. These prices are so cheap. I think I'll use some of my remaining cash to buy more at these lower prices. Then my stocks don't have to go up as much for me to get even.


Prospect Theory, Loss Aversion, and Holding onto Losing Trades
[IC: Let me explain why you end up holding so many losers in your portfolio? A key finding of Kahneman and Tversky Prospect Theory was that individuals form a REFERENC POINT from which they judge their performance. They found that from that reference point individuals are much more upset about losing a given amount of money than they are from gaining the same amount. They called this behaviour LOSS AVERSION and suggested that the decision to hold or sell an investment will be dramatically influenced by whether your stock has gone up or down, in other words, whether you have a gain or a loss.]

[IC: When you buy a stock, how do you track its performance? Exactly, you calculate how much the stock has gone up or down since you bought it. Often the reference point is the purchase price that investors pay for the stock. Investors become fixated on this reference point to the exclusion of any other information. This investor behaviour is referred to as MENTAL ACCOUNTING.
When you buy a stock, you open a mental account with the purchase price as the reference point. Similarly, when you buy a group of stocks together, you will either think of the stocks individually or you may aggregate the accounts together. Whether your stocks are showing a gain or a loss will influence your decision to hold or sell the stock. Moreover, in accounts with multiple losses, you are likely to aggregae individual losses together because thinking about one big loss is an easier pill for you to swalllow than thinking of many smaller losses. Avoiding the realisation of losses becomes the primary goal of many investors.]

[IC: Dave, you mentioned that the thought of realizing the losses on your technology stocks petrified you. That is a completely natural reaction. Your pride is one of the main reasons why you avoided selling at a loss. Every investment involves an emotional as well as a financial commitment that makes it hard to evaluate objectively. You felt good that you sold out of your Internet stocks with a small gain, but the networking stocks you subsequently bought never showed a gain. Even as prospects dimmed, not only did you hang onto those stocks, but you also bought more, hoping against hope that they would recover.
Prospect theory predicts that many investors will do as you did - increase your position, and consequently your risk, in an attempt to get even. ]

[IC: You thought that buying more stock would increase your chances of recouping your losses. Millions of other investors think likewise. In 1982, Leroy Gross wrote a manual for stockbrokers and called this phenomenon the "GET-EVEN-ITIS" disease. He claimed "get-even-itis" probably has caused more destruction to portfolios than any other mistake.
It is hard for us to admit that we have made a bad investment and it is even harder for us to admit that mistake to others. To be a successful investor, however, you have no choice but to do so. Decisions on your portfolio must be made on a FORWARD-LOOKING basis. What has happened in the past cannot be changed. It is a "SUNK COST," as economist say. When prospects do not look good, sell the stock whether or not you have a loss. ]

[IC: You bought more shares because you thought the stocks were cheap, as many were down 50 % or more from their highs. Cheap relative to what? Cheap relative to their past price or their future prospects? You thought that a price of 40 for a stock that had been 80 made the stock cheap, yet you never considered the fact that maybe 40 was still too high. This demonstrates another one of Kahneman and Tvrsky's behavioural findings: ANCHORING, or the tendency of people facing complex decisions to use an anchor, or a suggested number, to form their judgement. Figuring out the correct stock price is such a complex task that it is natural to use the recently remembered stock price as an anchor and then judge the current price a bargain. ]

[IC: You are concern that following my advice and selling your losers whenever prospects are dim will register a lot more losses on your trades. Good! Most investors do exactly the opposite and realize poor returns. Research has shown that investors sell stocks for a gain 50% more frequently than they sell stocks for a loss. This means that stocks that are above their purchase price are 50% more likely to be sold than stocks that are in the red. Traders do this even though it is a horrible strategy from the point of view of paying taxes.
Let me tell you of one short-term trader I successfully counseled. He showed me that 80 percent of his trades made money, but he was down overall because he lost so much money on his losing trades that they drowned out his winners.
After I counseled him, he became a successful trader. Now he says that only one-third of his trades make money but that overall he is way ahead. When things do not work out as he planned, he gets rid of losing trades quickly while holding onto his winners. There is an old adage on Wall Street that sums up successful trading: "Cut your losers short, and let yours winner ride." ]


TIME: August 2001

Jen: Dave. I've just looked at our broker's statement. We've been devastated! Almost three-quarters of our retirement money is gone. I thought you were going to monitor our investments closely. Our portfolio shows nothing but huge losses.

Dave: I know; I feel terrible. All the experts said these stocks would rebound, but they kept going down.

Jen: This has happened before. I don't understand why you do so badly. For years you watch the market closely, study all these financial reports, and seem to be very well informed, yet you seem to always make the wrong decisions. You buy near the highs and sell near the lows. You hold on to losers while selling your winners. You...

Dave: I know, I know. My stock investments always go wrong. I think I'm giving up on stocks and sticking with bonds.

Jen: Listen, Dave. I have talked to a few other people about your investing troubles, and I want you to go see an investment counselor. They use behavioural psychology to help troubled investors understand why they do poorly. The invstment counselor even suggests ways to correct this behaviour. Dave, I made you an appointment already. Please go see her.

Related:
Behavioural Traps (1)
Behavioural Traps (2)
Behavioural Traps (3)


Ref: Stock for the Long Run by Jeremy J. Siegel 3rd Edition Pages 316-327