When it comes to investing, one of the biggest hurdles we must face is ourselves. Study after study has demonstrated that individual investors routinely commit blunders that detract from their portfolio reaching its potential. Fortunately, the most common mental mistakes, which we are all hard-wired to make, have been well researched, meaning we can learn from the mistakes of others, and deny our base instincts. Three of the more common psychological traps we fall into include, loss aversion, status quo bias, and the endowment effect.
Loss aversion: I used the term “hard-wired” earlier, which is to say that many of our mental tendencies, have their roots in evolutionary biology. The notion of loss aversion, is probably best explained by a well-worn (yet effective) analogy, which goes something like this: imagine one of our primal ancestor, roaming the savannas of Africa, when she hears a rustle in the grass beside her. Without giving the source of the sound any real consideration, our ancestor immediately scrambles up the nearest tree. Most likely the rustling sound was caused by the wind, but on the off chance it was caused by a lion, our ancestor was hard-wired to react very rapidly, to even the slightest hint of a threat. Fast forward to today. Most of us at least, no longer face the threat of a lion in the grass, but our brains react just as rapidly to perceived threats. In fact, psychologists have found that we experience twice as much pain associated with a loss of X dollars, as we would experience joy from an equal but opposite gain of X dollars.
Putting this in terms of investment returns, research shows that we appreciate but forget gains, while our losses can haunt us forever. This can lead investors to be overly cautious, and paralyzed by an endless stream of negative business news, when in reality, they are best served by sticking to their investment strategy, come what may.
Status quo bias: assume you have a portfolio worth $500K and you are invested in a balanced portfolio with 60% stocks and 40% bonds. Your asset allocation was selected in accordance with a financial plan, and in consideration of your risk tolerances. In other words, your current asset allocation is thought to provide you with the best chance of achieving your long-term goals and objectives, with an appropriate trade-off between risk and return. Now, let’s assume that you have just received notification that a long-lost great uncle, has passed away and left you an inheritance of an additional $500,000, which you never anticipated. When the account is transferred to you, you find that your uncle had the money invested aggressively in a handful of junior stocks that he felt had good prospects. You now face a choice: Do you leave the new account invested as is, and see how your uncle’s picks work out, or do you sell his holdings, and reallocate the money to your existing strategy?
If you are like most people, you will have a strong tendency to let it ride, and leave the money invested in the way your uncle had preferred (the status quo portfolio), despite the fact that you carefully considered all portfolio options available when you constructed your existing portfolio, and decided that a balanced portfolio would most closely align with your long-term goals and objectives. This can be partially explained by our irrational tendency to account for money that we saved (the pre-existing $500,000) in a separate “mental bucket” than the new-found money we just inherited. This is irrational because regardless of which account we draw money from (the original account, or the new account) a dollar is still a dollar and will allow us to purchase the exact same amount of goods or services.
This leads us to the notion of the “endowment effect”, which was best described in a paper by Nobel Prize Winning Economist, Daniel Kahneman. Kahneman provides evidence that we become increasingly reluctant to part with something once we have established ownership of an asset. That is to say, that we are unwilling to sell an asset for a price that we previously believed to be too expensive before we owned the asset. An example of this is the “wine-loving economist”, who reluctantly purchased a crate of Bordeaux wine at auction for $10/bottle, and then subsequently saw the value of the wine increase to $200/bottle. The economist now enjoys the wine occasionally, but is unwilling to sell the wine at either his original purchase price of $10/bottle, or at its new value of $200. In this example, the economist is failing to act rationally. Previously his preference would have been to hold on to his $200 and not purchase a bottle of Bordeaux, today however, he would prefer to have the bottle of wine than trade it for $200. We see similar examples in real estate – people regularly appraise the value of their own home, to which they are emotionally attached, much higher than the near identical house down the street.
Bringing the ideas of loss aversion, status quo bias and the endowment effect together, brings me to a phenomenon we see regularly with our clients, and that is the preference not to sell a security that is in a loss. The story goes something like this: A new client transfers his assets to us because (among a myriad of reasons) he believes that our investment process provides better odds of a favourable long-term, and risk-adjusted, rate of return. Only one thing though, he is only comfortable selling existing portfolio assets that have increased in value. He would prefer to hold on to his losers until such time as he breaks-even. This is a natural inclination, and certainly one that I have harboured myself. The problem is that it’s flawed logic for a few reasons. First off, we should evaluate a security in precisely the same manner regardless of whether or not we currently own it. I can assure you that ABC Company, which he lost 30% on, feels absolutely no obligation to “pay him back”. So, the question we need to ask ourselves is, given the tens of thousands of investment options out there, if he had an additional $10,000 to add to his portfolio, would he select ABC Company as the best investment? If the answer is yes, then by all means, he should hold on to ABC Company, if the answer is no, it’s time to sell ABC.
Ultimately when facing the decision to sell a loser, we often prefer to protect ourselves from a perceived loss, even though doing so means foregoing future gains in an alternative investment. To put this into context, consider an investor who owns stock in a fictitious junior company (XYZ) that has been struggling to generate profits for the past five years when she originally purchased $10,000 worth of its stock. Today her investment in XYZ has declined by 50%, to $5,000. In order for that investor to recoup her original investment of $10,000, XYZ would have to increase in value by a whopping 100%, meaning something would have to dramatically change for XYZ. There is also a distinct possibility that XYZ continues to decline in value.
Let’s now assume that the investor is presented with an alternative investment that has been steadily growing at 10% per year, and has substantially less risk associated with it. The investor may think, 10% per year is not going to do it – I need that $5,000 to rapidly increase in value to breakeven. This may be completely detached from any reasonable expectation of XYZ’s future performance, and yet, the investor stubbornly holds on, waiting to claim victory over XYZ once and for all. Subconsciously she feels it is better to hold a paper loss, than be forced to admit defeat, sell and move on.
If the investor is acting completely rationally, meaning that she has diligently analyzed the prospects of XYZ, as well as the alternative investment, and she concludes that she is best served holding XYZ (meaning she expects it to outpace all alternatives on a risk-adjusted basis), the corollary questions must be: why doesn’t she double down? If she is that certain of XYZ’s prospects, why not add to the position with new money and capitalize on its expected rapid growth. Few investor ever take such action.
To be a truly good investor, we must always be making an honest appraisal of our abilities, including doing our best to understand what we don’t understand. We must also do our best to detach emotion from the investment process, and move on when we have made a bad decision. The truth is that no one is immune from the behavioural traps mentioned in this post. The good news is that we can overcome them, we just first must be aware that they exist.