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Wednesday, 25 May 2011

Profit From Self Knowledge

Gnôthi seauton! and is this the prime
And heaven-sprung adage of the olden time!
Say, canst thou make thyself? Learn first that trade;
Haply thou mayst know what thyself had made.

(Samuel Coleridge - Self Knowledge)

Behavioral Moneymaking

It’s easy to talk about the fundamental errors people make in investment but, in truth, we rarely get to see this in action. To judge from the terabytes of trading derring-do published daily you’d be hard pressed to find anyone who actually loses money on the stockmarket. Most people seem to adopt the attitude that, if these behavioral biases make a difference, it’s to other people and never themselves. And often, they believe their own rhetoric.

We can’t usually look inside individuals’ trading histories to point out the mistakes they’ve made, most research is based on gross, anonymised data. However, occasionally some anomaly allows us shed some light on the actual practice of real investors and such an opportunity arose with the trial and conviction of Martha Stewart for obstructing justice in an insider dealing case. Stewart may be a fine host, but she’s no better – or worse – at investing than most of us.

Martha Stewart’s Portfolio

Meir Statman, in Martha Stewart’s Lessons In Behavioral Finance, has handily analysed Ms. Stewart’s investment performance by looking at her trading record produced in court records. What he finds is a useful potted summary of the typical problems that beset most investors: a reluctance to realise losses, hindsight bias and regret and a tendency to scapegoat others for one’s own mistakes:
“Realizing gains as well as realizing losses is easier for investors who are able to turn financial advisers into regret-bearing scapegoats. Such investors take credit for choices that turn out well while shifting blame for choices that turn out poorly”.
As Professor Statman goes on to point out, rational investors don’t let emotions get in the way of business decisions and don’t fret over stuff that’s gone wrong. Equally he points out that it’s possible to overcome some of these biases by automating certain behaviours, such as a quarterly “harvesting” of losses. We may not be able to behave rationally, but we ought to be able to curb our more extreme bouts of stupidity. Assuming we can recognise them, of course.


So, the evidence shows that Ms. Stewart was sickened by the need to realise losses, not the first time we've seen celebrity loss aversion - as in Loss Aversion Affects Tiger Woods, Too - even though rational analysis would have shown that her "losses" were relative, and more than offset by her gains. Although some of those were, admittedly, ill-gotten. The theory is that there are a couple of behavioral biases and a bit of emotion involved in these beliefs.

The first problem is to do with framing, which is the way in which we view any given situation. (see Investors, You've Been Framed). Most investors, certainly naïve ones, frame an investment on the basis of a profit and loss account anchored on the buying price. Anchoring, the Mother of all Behavioral Biases, is behind many such errors. However, the price at which we buy a stock is a moment in time, irrelevant to the stock or the underlying company. By anchoring on her purchase price Martha Stewart was making the same error as most people: the truth is that a share is worth what it’s worth, not what we paid for it.

However, in Mental Accounting, Not All Money is Equal and in a mental profit and loss account, marked to the purchase value, we only need acknowledge our losses when we sell:
“[Investors] mark stocks to market only when they sell their stocks and close their mental accounts. Investors need not acknowledge paper losses because open accounts keep alive the hope that stock prices would rise and losses would turn into gains. But hope dies when stocks are sold and losses are realized.”
This reluctance to realize losses – the disposition effect – has been seen time and again in research. As Terrance Odean states:
“Investors exhibit disposition effects; that is, they realize their profitable stocks investments at a much higher rate than their unprofitable ones, except in December”.
December Effects

So what, you might be wondering, is so special about December? Well, outside the USA the answer is roughly “nothing”. However, in the States this is the deadline for taking a capital loss to set against taxes. Ms. Stewart, it turns out, was as typical an investor in this regard as everyone else. Statman, again:
“Postponing the realization of losses until December is one defense against regret. Normal investors tend to realize losses in December, and Ms. Stewart followed that practice when she realized her losses in December 2001. There is nothing rational in the role that December plays in the realization of losses … The real advantage of December is the behavioral framing advantage. What is framed as an investment loss in November is framed as a tax deduction in December”.
Of course, selling in December is doubly irrational, because that’s when everyone else is doing the same thing. This is momentum investing at its silliest, just in time for the silly season and inevitably leads, as January follows December, to a situation where:
“Investors postpone tax-gain selling of winners from December to January. The reduction in selling pressure on winners possibly causes them to earn a return of about 1.8 percent in the last five days of December, which is the December effect”.
So Rock On, January Effect.

Hindsight is a Wonderful Thing

The depositions of Martha Stewart’s trial also show up another common behavioural trait of investors: the grim inevitably of Hindsight Bias, which leads us to think we should have been able to foresee losses. This, you might think, is a relatively painless problem: the losses are real, whatever we may now think. However, hindsight bias triggers a sense of regret and we seem to be heavily conditioned to avoid the feelings of pain this engenders, even at the cost of rewriting our memories.

In the case of Ms. Stewart, and many other investors, December loss realization is linked to avoiding these feelings of regret because it enables them to be reframed. Another method of doing this, which her advisors also employed, is to swap assets, selling a loser to buy something else:
“Consider the mental accounting benefits of swaps recommended by Gross in his manual for brokers: “The two separate transactions (moving out of the loss and moving into a new position) are made to flow together by the magic words ‘transfer your assets.’ The prospect thought he was making a single decision, switching one investment into another. He was not being asked to think in terms of selling XYZ...”
There will doubtless be many readers who’ll recognise this trait. Learning to accept losses, rather than plunging the proceeds of a failed investment immediately into another one to avoid the regret associated with a mistake is an essential part of an investor’s armoury.

The Blame Game

Ms. Stewart also exhibited a third, nasty behavioural bias: the fundamental attribution effect, the tendency to blame others when things go wrong but to assume that when things go right it was her own skill. Admittedly, as the period under investigation was the dotcom crash and she was largely invested in technology stocks, there weren’t a great many successes to crow over: the portfolio lost 47% of its value between June 2000 and January 2001.
“Realizing gains as well as realizing losses is easier for investors who are able to turn financial advisers into regret-bearing scapegoats. Such investors take credit for choices that turn out well while shifting blame for choices that turn out poorly. They are depicted in a common broker lament: When the stock goes up the customer says, “I bought the stock,” and when the stock goes down the customer says, “My broker sold me the stock.””
Being Human

These three behavioral biases: the creation of mental accounts anchored on buying prices, the attempts to avoid painful feelings of regret triggered by realization of losses and the tendency to blame others for investments that go wrong, aren’t exclusive to Martha Stewart. She may be a very fine hostess, but she’s simply an average investor. Most of us are average investors.

Doing better than the average, while being average, requires us to recognise that we’re all subject to these effects: simply pretending that we’re somehow immune is simply pretending we’re not human. In fact even professional investors seem to be impacted by these problems:
“Professional traders, whose livelihood depends on their success, also exhibit the disposition effect - providing evidence that behavioral attributes are pervasive in the population”.
As ever, understanding ourselves is at least as important as finding the right stocks. Coleridge knew it long ago: investing in self-knowledge is one of the most important investments any of us can ever make.

Related articles: Loss Aversion Affects Tiger Woods, Too, Anchoring, the Mother of all Behavioral Biases, Mental Accounting, Not All Money is Equal, Hindsight Bias, Rock On, January Effect, Investors, You've Been Framed


  1. Thanks for this posting. For much more about investor behavior please see my new book :What Investors Really Want."

    Meir statman

  2. Book at: What Investors Really Want

    Professor Statman's blog at: What Investors Want and research articles at Research Articles.

    All well worth a good root around.