1. If it's gone down this much already, it can't go much lower.
2. You can always tell when a stock's hit bottom.
3. If it's gone this high already, how can it possibly go higher?
4. It's only $3 a share: What can I lose?
5. Eventually they always come back.
6. It's always darkest before the dawn.
7. When it rebounds to $10, I'll sell.
8. What me worry? Conservative stocks don't fluctuate much.
9. It's taking too long for anything to ever happen.
10. Look at all the money I've lost: I didn't buy it.
11. I missed that one, I'll catch the next one.
12. The stock's gone up, so I must be right, or ... The stock's gone down so I must be wrong.
Reference:
One Up on Wall Street by Peter Lynch
Showing posts with label Behavioural Traps. Show all posts
Showing posts with label Behavioural Traps. Show all posts
Wednesday, 18 September 2013
Wednesday, 31 July 2013
The importance of understanding your own behaviours in relation to your actions in investing; once understood, you will be able to apply your preferred investing style consistently without emotional or psychological bias.
The person capable of standing back may notice that change is the one constant.
One might do well to stand back and consider whether a perceived truth is indeed so, or whether in fact the more things apparently change, the more some things do indeed remain the same.
Following the crowd and abandoning a commitment to a long-term approach in a business you bought into believing it to be sound could lead to a real loss, especially if, six months later, it turns out that the crowd consisted of ill-informed speculating lemmings and now the shares you sold have doubled in value as sanity returned to the market.
The importance of understanding your own behaviours in relation to your actions cannot be over-stated.
Once understood, you will be able to apply your preferred investing style consistently without emotional or psychological bias. Something which is easier said than done.
One might do well to stand back and consider whether a perceived truth is indeed so, or whether in fact the more things apparently change, the more some things do indeed remain the same.
Following the crowd and abandoning a commitment to a long-term approach in a business you bought into believing it to be sound could lead to a real loss, especially if, six months later, it turns out that the crowd consisted of ill-informed speculating lemmings and now the shares you sold have doubled in value as sanity returned to the market.
The importance of understanding your own behaviours in relation to your actions cannot be over-stated.
Once understood, you will be able to apply your preferred investing style consistently without emotional or psychological bias. Something which is easier said than done.
"An optimist will tell you the glass is half-full;
the pessimist, half-empty; and
the engineer will tell you the glass is twice the size it needs to be."
Sunday, 20 May 2012
Behavioural Finance Solutions
Dale Carnegie ..... How to stop worrying.
What is the worst that can happen if you take a decision.
Analyze the facts and the situation: it may not be as bad as you think.
Be prepared for the worst.
GO AHEAD AND TAKE THE DECISION.
Thursday, 20 January 2011
Market Behaviour: Control Yourself (Patience)
Patience is a virtue you must learn in order to excel as a value investor. You must think outside the box and move in a direction the crowd likely is not following.
If you want to invest intelligently according to the basics established by value investing master guru Benjamin Graham, you must control the following:
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If you want to invest intelligently according to the basics established by value investing master guru Benjamin Graham, you must control the following:
- Your brokerage costs
- Your ownership costs
- Your expectations
- Your risk
- Your tax bills
- Your own behaviour
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1. Your Brokerage Costs
Find yourself a good broker who doesn't charge too much to handle your stock trades. If you feel confident that you know how to handle stock trading, do it yourself with an Internet discount broker.
We don't recommend full-service brokers because you don't need their research services and you certainly won't want to follow their advice - unless by some lucky break you find a broker who truly believes in value investing.
Also, don't trade too often and waste your money jumping in and out of stocks. Most value investing gurus hold on to stocks for four to five years.
Learn to be patient and give a stock you've picked time to recover. Its price may go down after you buy the stock, so don't get discouraged. Few people can actually buy at the absolute lowest price. Most value investors choose a stock on its way down.
But don't be so patient that you end up losing all your money. Sometimes, you will make a mistake when picking a stock. Just admit your mistake, accept your losses and move on.
2. Your Ownership Costs
If you decide to invest using mutual funds, be sure to buy no-load funds with very low management fees. Few funds are worth the cost if their management fees are more than 1 percent.
Remember, for a mutual fund manager to meet the returns of a stock market index, he or she must beat the index by at least the cost of the mutual fund's management fees. Management fees are a drain on all mutual funds.
Unless for some reason you've picked a particular mutual fund manager you want to follow, your best bet is to invest using an index fund. Fees for many index funds are just 0.15 to 0.35 percent.
3. Your Expectations
Always be realistic about the returns you want to get out of a stock purchase. Even if you decide to follow some newsletters that specialise in value investing, don't get caught up in someone else's hype. You'll never be disappointed if you carefully assess the true value of a stock and are conservative about the cash flows you can expect from the stock purchase.
4. Your Risk.
Keep a close eye on the amount of risk you can tolerate. Determine the asset allocation that best manages your risk tolerance.
Periodically re-balance your portfolio so you know that you're maintaining your portfolio at a risk tolerance level that you can tolerate.
Determine how much of your portfolio you can afford to put at risk. Stock investing is a risky business. You can afford to take more risk if you have a longer time frame before you need the money.
For example, if you won't need the money for 10 years or more, you can take on the greatest amount of risk. If you plan to use the money in two years, put that money in a cash account.
5. Your Tax Bills
Each time you sell a stock, you may have to pay taxes on the amount of profit you make from the transaction. If you hold a stock for less than 12 months, the taxes you pay are based on your current tax rate.
If you hold a stock for more than 12 months, your tax bill could be as little as 5 percent for capital gains, if you are in the 10 percent or 15 percent tax brackets. You'll pay 15 percent capital gains tax if your tax bracket is 25 percent or higher.
Unless you've made a terrible mistake picking a stock, you should always hold it for more than a year, to minimize the tax hit on any gain. The only exception to this rule is fi you have a significant profit in a stock and you're afraid the stock could take a tumble.
6. Your Own Behaviour
It's human nature to get excited and follow the crowd in feeling good about a stock. The crowd shows its enthusiasm when it bids the price up so high that the P/E ratio tops 20. Learn to resist these feelings.
It;s also human nature to get frightened when everyone is running from the stock market. Get your emotions under control and start to take a look for good buys when everyone else thinks it's time to escape.
Related topics:
Sunday, 28 November 2010
Behavioural Risks
Sunday, November 28, 2010
Investment Madness
We are all prone to having psychological preconceptions or biases that make us behave in certain ways. These biases influence how we assimilate the information we come in contact with on a daily basis. They also have an impact on how we utilize that information to make decisions.
Our very own psychological biases have an impact on our investment decisions and affect our attempts at building wealth.
Psychological Bias | Effect on Investment Behavior | Consequence |
Overconfidence | Trade too much. Take too much risk and fail to diversify | Pay too much in commissions and taxes. Susceptible to big losses |
Attachment | Become emotionally attached to a security and see it through rose-colored glasses | Susceptible to big losses |
Endowment | Want to keep the securities received | Not achieving a match between your investment goals and your investments |
Status Quo | Hold back on changing your portfolio | Failure to adjust asset allocation and begin contributing to retirement plan |
Seeking Pride | Sell winners too soon | Lower return and higher taxes |
Avoiding Regret | Hold losers too long | Lower return and higher taxes |
House Money | Take too much risk after winning | Susceptible to big losses |
Snake Bit | Take too little risk after losing | Lose chance for higher return in the long term |
Get Even | Take too much risk trying to get break even | Susceptible to big losses |
Social Validation | Feel that it must be good if others are investing in the security | Participate in price bubble which ultimately causes you to buy high and sell low |
Mental Accounting | Fail to diversify | Not receiving the highest return possible for the level of risk taken |
Cognitive Dissonance | Ignore information that conflicts with prior beliefs and decisions | Reduces your ability to evaluate and monitor your investment choices |
Representativeness | Think things that seem similar must be alike. So a good company must be a good investment | Purchase overpriced stocks |
Familiarity | Think companies that you know seem better and safer | Failure to diversify and put too much faith in the company in which you work |
Thursday, 1 July 2010
Monday, 31 May 2010
The process of deciding to sell a stock is a difficult one unless an investor has developed a methodology.
The process of deciding to sell a stock is a difficult one at best unless an investor has developed a methodology and adheres to it mechanically in order to avoid inevitable internal mental battles.
When a loss is involved, the sell decision is even more difficult because the issue of pain-avoidance is now present.
It is human nature to seek self-preservation, and pain is a phenomenon that indicates a danger to well-being.
Some investors are obsessed with safety, but most are reasonably balanced in their tolerance of the risk involved in earning a profit. But every investor has some threshold at which pain is avoided, sometimes at ridiculous cost.
Dealing with an investment or trading loss involves not only financial pain, but also ego pain. A majority of shareholders at some point attempt to avoid both pains by failing to deal with the reality of their losses.
One of the most convenient ways to avoid the pain of loss - or even of profit squandered - is denial. They prefer not to think about it, or they minimize it.
When specific stock positions go bad, the pain-avoider becomes a longer-term holder who is more accurately a collector of stocks. He has no real investment motive or astuteness of value judgement and is, in fact, simply denying the pain of potential loss.
When a loss is involved, the sell decision is even more difficult because the issue of pain-avoidance is now present.
It is human nature to seek self-preservation, and pain is a phenomenon that indicates a danger to well-being.
Some investors are obsessed with safety, but most are reasonably balanced in their tolerance of the risk involved in earning a profit. But every investor has some threshold at which pain is avoided, sometimes at ridiculous cost.
Dealing with an investment or trading loss involves not only financial pain, but also ego pain. A majority of shareholders at some point attempt to avoid both pains by failing to deal with the reality of their losses.
One of the most convenient ways to avoid the pain of loss - or even of profit squandered - is denial. They prefer not to think about it, or they minimize it.
When specific stock positions go bad, the pain-avoider becomes a longer-term holder who is more accurately a collector of stocks. He has no real investment motive or astuteness of value judgement and is, in fact, simply denying the pain of potential loss.
Sunday, 24 May 2009
Behavioural Traps (3)
Rules to Avoid Behavioural Traps
(Continuing the investing story of Dave and his Investment Counselor)
Dave: I don't feel secure enough to trade again soon. I just want to master investing. How can one get over these behavioural traps and be a successful long-term investor?
IC: Dave, I'm glad you are not trading, since trading is right for only a very small fraction of my clients.
Researchers have found that you must set up rules and incentives to keep your investments on track - this is called PRECOMMITMENT. Set an ASSET ALLOCATION RULE and then stick to it. If you have enough knowledge, you can do this alone or else with an investment advisor. Do not try to second guess your rule. Remeber that the basic factors generating returns change from less than we think as we watch the day-to-day ups and downs of the market. A disciplined investment strategy is almost always a winning strategy. Furthermore, you need to get rid of the temptation to trade stocks. One way to do this is by closing all your trading and online accounts. If you have to pay higher commissions, you are less likely to trade more frequently.
If you do buy stocks for a short-term trade, set a stop-loss order to minimize your losses. You do not want to let your losses mount, rationalizing that the stock will eventually come back. If you are tempted to sell a stock that has a gain, think of the taxes you will have to pay, and if you are reluctant to sell a stock that has a loss, think of the tax savings you will realize. Finally, do not tell your friends about your trades. Living up to their expectations will make you even more reluctant to take a loss and admit that you were wrong.
Dave: I'll have to admit that I sometimes enjoyed trading.
IC: If you really enjoy trading, establish a rule that every year you are going to establish a small trading account that is completely separate from the rest of your portfolio. All brokerage costs and all taxes must be paid from this account. Consider the money you put into the account lost, because most likely it will wither to nothing, being consumed by transaction costs and trading losses. And you should never consider exceeding the rigid limit you place on how much money you put into that account.
If that does not work, or if you feel nervous about the market and have a compulsion to trade, seek help. There are some reformed traders establishing Traders' Anonymous (TA) programs designed to help people who cannot resist the temptations of trading too frequently.
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
(Continuing the investing story of Dave and his Investment Counselor)
Dave: I don't feel secure enough to trade again soon. I just want to master investing. How can one get over these behavioural traps and be a successful long-term investor?
IC: Dave, I'm glad you are not trading, since trading is right for only a very small fraction of my clients.
Researchers have found that you must set up rules and incentives to keep your investments on track - this is called PRECOMMITMENT. Set an ASSET ALLOCATION RULE and then stick to it. If you have enough knowledge, you can do this alone or else with an investment advisor. Do not try to second guess your rule. Remeber that the basic factors generating returns change from less than we think as we watch the day-to-day ups and downs of the market. A disciplined investment strategy is almost always a winning strategy. Furthermore, you need to get rid of the temptation to trade stocks. One way to do this is by closing all your trading and online accounts. If you have to pay higher commissions, you are less likely to trade more frequently.
If you do buy stocks for a short-term trade, set a stop-loss order to minimize your losses. You do not want to let your losses mount, rationalizing that the stock will eventually come back. If you are tempted to sell a stock that has a gain, think of the taxes you will have to pay, and if you are reluctant to sell a stock that has a loss, think of the tax savings you will realize. Finally, do not tell your friends about your trades. Living up to their expectations will make you even more reluctant to take a loss and admit that you were wrong.
Dave: I'll have to admit that I sometimes enjoyed trading.
IC: If you really enjoy trading, establish a rule that every year you are going to establish a small trading account that is completely separate from the rest of your portfolio. All brokerage costs and all taxes must be paid from this account. Consider the money you put into the account lost, because most likely it will wither to nothing, being consumed by transaction costs and trading losses. And you should never consider exceeding the rigid limit you place on how much money you put into that account.
If that does not work, or if you feel nervous about the market and have a compulsion to trade, seek help. There are some reformed traders establishing Traders' Anonymous (TA) programs designed to help people who cannot resist the temptations of trading too frequently.
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
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
(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
Behavioural Traps (1)
Behavioural Traps (1)
(The investing story of Dave and Jennifer)
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.
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.
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.
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
(The investing story of Dave and Jennifer)
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.
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.
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.
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
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