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Behavioral Investing:
How to Succeed Despite Love, Fear and Greed

John Price, Ph.D.

You ache all over. Your head is throbbing. One minute you are sweating like you have been playing tennis for an hour, the next you are shivering. We are all too familiar with the symptoms of the flu. When it hits us there is little we can do except grin and bear it until it passes.

Not so clear are the symptoms of chronic diseases. We have the vague feeling that something is not quite right. Less energy, slight twinges. All actions take more effort, and the results rarely meet our expectations.

The same difference exists in the share market. On the one hand, we have acute illnesses like the collapse of Enron or WorldCom In the USA or HIH and One-Tel in Australia. When you are hit by it, there is little you can do except bear the pain.

On the other hand, just as with our physiology, there are also chronic diseases in investing. These can be even more damaging to your investment health than acute diseases.

The symptoms are often a vague feeling that something is wrong. Or, more seriously, we may not even know that we have been infected. But the chronic diseases of investing eat away at your investing success, day after day, week after week, year after year.

No matter how hard you try, your returns are just not what you hoped or expected.

As for medical chronic diseases, there are many classes of chronic investment diseases. I am just going to mention the diseases in one of these classes, the behavioral chronic diseases of investing.

I shall mention six of these, namely Get-Evenitis, Consolidatus Profitus, Tradophilia, King Kong Syndrome, Lotto Syndrome, and Success Addiction.

The basis of all these diseases is fuzzy thinking. So, before explaining the diseases, I would like to give an example of fuzzy thinking.

You are going to be given two scenarios and in each scenario you will be given two alternatives. Choose one of the alternatives in each scenario. Don't spend too much time on it. Just choose the alternative that first comes to your mind.

Scenario 1 In addition to whatever you own, you have been given $1,000. Which of the following two alternatives would you choose?
  A1: A sure gain of a further $500,
     OR 
  B1: A 50% chance to gain a further $1,000 and a 50% chance to gain nothing.

Remember what your choice was. Better yet, write it down and try to put it out of your mind.

Scenario 2 In addition to whatever you own, you have been given $2,000. Which of the following two alternatives would you choose?
  A2: A sure loss of $500,
     OR
  B2: A 50% chance to lose $1,000 and a 50% chance to lose nothing.

What was your choice this time? Were your two choices the same or different?

Don't read on until you have made your choices.

Did you think the two scenarios were different or the same? It comes as a surprise to most people to learn that technically they have exactly the same cash flows.

In both cases if you choose the first alternative you have a sure gain of $1,500. For example, in Scenario 1 the first alternative is $1000 + $500 = $1,500 and in Scenario 2 the first alternative is $2,000 - $500 = $1,500.

An analysis of the second alternative in both Scenarios gives a 50/50 chance of gaining $2,000 or of gaining $1,000.

Even though technically the same, most people choose the first alternative in Scenario 1 and the second alternative in Scenario 2. (When these scenarios were presented to two groups of subjects by researchers Kahneman and Tversky in 1979, they found that 84% of the subjects chose A1 in the first scenario while 69% chose B2 in the second scenario.)

The explanation for this is that in the first scenario people favored the first choice because they did not want to gamble when the expected return of $500 for the gamble was the same as the guaranteed return of $500 for the sure profit.

In the second scenario, people favored the gambling alternative because they saw it as a way of avoiding the sure loss of the first alternative.

Another way of explaining this is that people do not like to lose and will often gamble to avoid this occurrence. On the other side, people are less likely to adopt a gambling strategy in the hope of making an excess profit.

Get-Evenitis
What happens when you buy a stock and it drops by 30 percent? Do you sell or do you hang on hoping that it will come back to its original price? If you usually hang on, then you may be suffering from get-evenitis, a highly contagious disease particularly among males.

If you buy XYZ for $20 and it drops to $12, you now own a $12 stock. It does not matter how it arrived at this price. The question now becomes, "If I had $12, would I buy a unit of XYZ or would I buy something else?" If the answer is to buy XYZ, then hang on to it. Otherwise sell it. Unfortunately our ego will goad us into all sorts of rationalizations why we should not sell at a loss.

We want to be able to say, "It's only a paper loss. Don't worry. It will come back." Worse than having our teeth pulled is being forced to utter "I made a mistake." Even "There was a downturn in the market which caused XYZ to go south" is hard for most of us to say. Just as in real life, sometimes we have to face our mistakes and accept a loss before we can move on.

In 1995 Nicholas Leeson became famous for causing the collapse of Barings Bank, his employer. Over the previous years he had some serious losses. Instead of admitting them, in his own words, he "gambled on the stock market to reverse his mistakes and save the bank." But things just got worse and he ended up losing US$1.4 billion.

It is unlikely that any of us are going to catch such an acute case of get-evenitis. More likely it will be a low-grade infection that eats away at our investing profits.

Consolidatus Profitus
Get-evenitis has an associated disease called consolidatus profitus. Where you see one, you usually see the other. Sufferers of consolidatus profitus are often heard intoning "You can't lose money by taking a profit."

You may not lose money for that particular stock, but in the end what makes the difference is what we do with our profits. What if we put the money from the sale into a stock that is a major underperformer? We may be able to say that we made a profit on a particular stock. What we are not saying is that our portfolio went down because of the way we spent the profits.

If ABC goes from $20 to $30, then you now own a $30 stock. In the same way that you examined the loser above, think what you would do with $30. If you would buy ABC for $30, then keep the stock. If not, then sell it.

Of course, in real life things are a bit more complicated since we have to take into account transaction costs and taxes. But I think the general idea is clear-evaluate your stocks on what return you expect to get from them in the future, not on what they have done in the past.

Just how widespread are these diseases follows from a large-scale study carried out by Terrance Odean of the University of California in Davis. Reporting in the Journal of Finance, 1998, he found that people tended to sell winners and put the money into stocks that performed less well. Overall he found that people would have been better to sell their losers and keep their winners. Instead, they did the opposite, namely they kept their losers and sold their winners.

To get a rough idea of the size of the losses, imagine an investor that has two stocks to sell, one a past winner and the other a past loser. Using data from Odean's study, the average return on the past winner over the next year was 2.4 percent above the market average compared to a 1 percent loss on the past loser.

This means that holding on to your winner would put you 2.4 percent ahead of the market during the next year. In contrast, holding on to the loser would put you 1 percent behind the market. But this is just what the average investor did. On average, investors choose to sell their winners more often than their losers.

Tradophilia
This is an infatuation with the thrill of trading. Barber and O'Dean showed that there is a inverse correlation between the number of trades a person made each year and how well he or she performed in the market. In other words, on average the more trading the lower the profit even when the transaction cost are taken into account.

King Kong Syndrome
In July 1993, Robert Citron, the treasurer of Orange County, California, predicted that interest rates would not rise. When asked how he knew this, he replied, "I am one of the largest investors in America. I know these things." Within a little over a year it was public knowledge that Citron was deluding himself. His prediction of how interest rates would move was wrong, his error causing the Orange County Investment Pool to lose $2 billion forcing the County into bankruptcy.

This is an extreme example of what I call the King Kong syndrome, the disease of arrogance and hubris.

Lotto Syndrome
State run lotteries hit on a goldmine when they allowed the participants to choose their own numbers rather than be simply given a ticket. With this small change in the way people can choose their tickets they now feel in control. They can choose their own numbers and so have the illusion of increasing their chances of winning. This illusion of control, as it is referred to by the psychologists, leads to overconfidence.

We see examples of this illusion of control in people collecting all sorts of financial data whereas there is no evidence that much of this data has anything to do with share performance.

Success Addiction
Our irrational love of success can cause us not to face the fact that we may have made a mistake.

Remedies
We all have these investment diseases to varying degrees and perhaps it is impossible to be completely free of them. One of the best ways I know of strengthening our immune systems so that the diseases are kept at a tolerable level is to keep a stock book. Before you buy a stock in a company write down some of its key features with particular emphasis on those things that you consider most important for your decision making process.

Peter Lynch was a great advocate of recording his thoughts on different companies. When he was the manager of the Fidelity Magellan Fund, Lynch kept a series of notebooks in which he wrote down information on companies that he analyzed or visited. He also required that his advisors be able to make brief presentations on any companies that they thought should be considered for the fund. Perhaps you could try this with your spouse or a friend.

A pilot friend of mine says that his rule for when there is a difficult situation is to "put your seat back a few notches." This means to sit back and try to take a calm and more dispassionate view. This seems like pretty good advice to follow each time we are about to buy, or sell, another share. This is the advantage of the Conscious Investor. It provides proven steps to locate quality companies at excellent prices while at the same time filtering out the over-priced and speculative companies.

 

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