By: Philip Weiss, CFA , CPA | Chief Investment Analyst
Why do investors often have a tendency to sell stocks when they are low and buy them when they are high? When investing, our emotions can often overrule our well-thought-out plans. As the market bottomed during its last bear phase in 2009’s first quarter, most investors were afraid of adding new money. More savvy investors realized that while the timing of the next upturn was far from certain, there were opportunities to acquire shares of high-quality companies at attractive prices that could lead to strong long-term gains. Concerns about avoiding losses outweighed the potential for long-term gains and kept many investors on the sidelines.
In his book The Intelligent Investor, which was first published in 1949, Ben Graham, the father of value investing, said, “The investor’s chief problem – and even his own worst enemy – is likely to be himself.” Unfortunately, these words still apply. Emotion, bias, and overconfidence are just three of the numerous behavioral traits that can negatively impact investment returns. Behavioral finance has become a recognized part of the investment lexicon.
Behavioral finance is a relatively new field that seeks to combine behavioral and cognitive psychological theory with conventional economics and finance to provide explanations for why people make principles can be applied to an investment process to help investors avoid, or at least minimize, some of the mental mistakes that can so often hamper returns.
Behavioral finance practitioners and academics alike agree that human beings are flawed, which, of course, we are. We can and do make bad decisions, particularly when confronted by uncertainty. It is hard to imagine anything more uncertain than the financial markets. As a result, investing is rife with examples of irrational behavior. Pioneers in behavioral finance, such as Daniel Kahneman, a psychologist who won the Nobel Prize in economics in 2002 and the author of Thinking Fast and Slow, often present compelling examples of the ways that people can make poor choices in situations where there are markedly better alternatives. In the discussion that follows, we will describe some common behavioral biases as well as ways in which they can potentially be addressed.
SUNK-COST FALLACY (SCF)
Have you ever started a book and realized you were not enjoying reading it and finished it anyway? If so, you may have fallen victim to the sunk-cost fallacy. When you continue to put time, energy or money into something because you have already made an investment in it and refuse to cut your losses and acknowledge that you cannot get back those “sunk costs” you are likely under the grips of the sunk- cost fallacy. In financial terms, this bias refers to the concept of “throwing good money after bad” or doubling up on an investment when you believe in the story behind the stock, even though the business’ performance does not justify the additional capital. One way to help minimize the risk of the SCF is to take a fresh look at a stock that works against you before committing new money. As part of this process, you should also attempt to understand the point of view of those who think differently.
LOSS AVERSION
In some ways, the SCF is closely related to another bias called loss aversion. This happens when we try to avoid losses because they feel too painful. In short, it is much more painful to sell a stock at a loss than it is to sell a stock for a profit. In his classic book on investing, Common Stocks and Uncommon Profits, Philip Fisher wrote, ”More money has probably been lost by investors holding a stock they really did not want until they could ‘at least come out even’ than from any other single reason.” One way to combat this bias is to remind ourselves that the money that remains tied up in the losing stock is keeping us from another, potentially better idea. In addition, if the losing investment is in a taxable account, selling it can also cut your tax bill. Viewing the sale of such losers as “tax loss harvesting” is another way to make recognizing a loss more palatable.
ANCHORING
The concept of anchoring draws on the tendency to attach or “anchor” our thoughts to a reference point – even though it may have no logical relevance to the decision at hand. For example, some investors may purchase shares of companies that have fallen considerably in a very short amount of time, simply because the share price has dropped sharply. In this case, the investor is anchoring on a recent “high” that the stock achieved and consequently believes that the drop in price provides an opportunity to buy the stock at a discount. However, just because a stock traded at a specific price does not necessarily mean that price was justified. When it comes to avoiding anchoring, there is no substitute for rigorous critical thinking.
Be especially careful about which figures you use to evaluate a stock’s potential. Successful investors do not just base their decisions on one or two benchmarks; they evaluate each company from a variety of perspectives in order to derive the truest picture of the investment landscape.
SUMMARY
Whether you realize it or not, the psychology of investing says you have naturally held cognitive biases that could affect the way you make decisions about your portfolio. It is important that investors be aware of these potential biases and also consider ways to combat them, so that they do not negatively impact performance.