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Monday, 30 December 2013

Behavioral Resolutions for Behavioral Investors

Death or (um ... ) Death

Apparently the ancient Babylonians would, at the start of each year, promise to pay off their debts and return stuff that they’d borrowed, like the lawnmower (or, as we would refer to it, the neighbor’s goat). As we saw in On Incentives, Agency and Aqueducts  they had good reason to be cautious as the punishment for theft was death. Although, to be fair, the punishment for everything in Ancient Babylonia was death. What they lacked in imagination they made up for in consistency.

These days we have less strict incentives to keep to our New Year Resolutions, but would probably find ourselves wealthier if we could stick to a few simple rules. The essence of being a psychologically aware investor is self-control, and what could be less modern and more ancient than that?

Uncertainty in a Modern World

Generally people make two sorts of investing mistakes. Firstly we make mistakes of analysis: we’re busily forecasting in a world in which the future is at best shrouded in uncertainty. We can’t possibly get all decisions correct. Secondly we make psychological mistakes: our minds betray us into making decisions in which the balance of probable outcomes lies against us. And, to compound the issue, we usually ascribe the latter sort of mistake to the former sort of category: we blame the uncertainty of the world for the mistakes of our minds.

There are lots and lots of variants of behavioral bias – I keep The Big List of Behavioral Biases as an amusing aide memoir to the complexity and multiplicity of our ingrained inability to think straight, but there are a few simple things we can do to reduce our error rates and, ultimately, improve our returns. If the Babylonians could do it, I don’t see why we shouldn’t.

So, before we embark on and embrace another year of monetary mayhem, here are a few simple resolutions to guide us on our way.

I Will Not Sell Winners To Buy Losers

Our number one stupid behavior is selling winners to buy losers. This is one of the most famous pieces of research ever done in the area, by Brad Barber and Terrance Odean, and they showed that overwhelmingly the stocks that internet traders sold went on to outperform the ones they purchased to replace them, an outcome of overconfidence. This tendency to sell winners and buy losers is known as the disposition effect, but is a facet of loss aversion, our inability to sell at a loss.

The outcome of this is simple: we grimly hold onto to losers in the hope they’ll come good while we sell our winners to bank a guaranteed profit. “You never go wrong taking a profit” goes the old proverb. Well phooey to that. Winners should only be sold if they are significantly overpriced, otherwise a good stock is likely to keep on winning.

I Will Track My Returns

It’s a remarkable fact that most investors don’t know whether they’re making money or not. In fact, when research has looked at how well people do during bull markets it turns out that they perform much, much less well than the markets – but they don’t know it. The main reason for this abject performance is that they trade away their profits by attempting to time the markets when they’d simply be better off riding them.

Unfortunately there’s no simple way of convincing you or anyone else of this – it can only be done through the simple expedient of keeping proper records. Of course, the people who need this most are the ones that think they need it least. This is an aspect of blind spot bias, the issue being that most of us will accept that other people are biased, but refuse to agree that we ourselves are. Well, phooey to that, too.

I Will Treat All Money As Equal

Our hatred of taking a loss and our unwillingness to track our returns means that we play mental games with our money. To be precise we allocate different sorts of money to different sorts of mental accounts, and we then use these accounts to hide away losses. We looked at an example of this in Behavioral Portfolios where people have risky accounts and safe accounts and get all upset when safe investments turn out to be risky ones.

It’s all the same pot of money; don’t treat different sets of investments or securities separately from others, because this opens you up to lots of nasty issues that we need to avoid. My particular favourite is when people partially sell some stock that’s done well in order to let the rest “run for free”, the idea being that if you end up losing it all it doesn’t matter because you’ve already covered your investment. This is the epitome of loose thinking, and the worst sort of mental accounting. Don’t do it.  Phooey, phooey, phooey.

I Will Not Listen To Fake Gods (or Experts)

In an uncertain world such as that of investing there’s not really much prospect of anyone getting short-term forecasting right on a regular basis. Most experts are talking heads, and most forecasts are simply projections of the recent past – because actually projecting the recent past into the near future will be right most of the time. The trouble is that when it’s not right it’s not a bit wrong: it’s totally and utterly and disastrously wrong.

If you’d rather accept the advice of third-parties rather than do your own heavy lifting then you really have no business investing for yourself. Investment “experts” are just as fallible as you and me because they’re operating in an environment characterized by uncertainty. Unfortunately humans are particularly attracted to people who express opinions with great confidence and utterly useless at checking whether those opinions turned out to correct. Make your own mistakes, just make sure you recognize them when you do: that way at least you get the benefit of learning from them.

I Will Not Fall Victim To Temptation

We are all, to some extent, hobbled by our inability to stick to our resolutions. Real life keeps getting in the way. We have busy lives, comprised of lots of moving parts, which make it difficult for us to be consistent. In the short-term the most likely reason we will fail to keep our promises to ourselves is emotion – and for this reason we need to try and avoid making investing decisions when in a tired or emotional state. Many of the most experienced professional investors avoid investing during periods of great market uncertainty, partly because they can’t make any kind of prediction, and partly because it’s difficult to separate the market turmoil from their mental states.

In the longer-term, however, this is down to you. If you can’t demonstrate self-control, if you can't resist that tempting treat, can’t help flashing the credit card to get that glitzy gizmo and would rather buy now and pay later you’re unlikely to be able to demonstrate the discipline needed to overcome issues of behavioral investing bias. Fortunately you’ll probably never know it, and the rest of us can get on with making money out of your misfortune. Ho hum.

But There Is More To Life Than Money

Finally, though, remember that money does not make us happy. What we do with money can make us happy, especially if we buy ourselves and our loved ones experiences. A new possession gives us a temporary lift but a joint experience is something that can be relived time and time again, and usually grows in the retelling.

Investing is a means to end. Just make sure you understand both the means and the end. Oh, and now might be a good time to return the neighbor's lawnmower.

I hope you all had a successful and happy 2013, and wish you a better 2014.

Tim


   




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3 comments:

  1. We need a name for the psychological bias that make people think that behavioural biases always produce adverse effects.

    PnL biases are a good example: trading in response to individual PnL events is essentially random trading (the PnL events are information-free at the world level) which as such is neutral in the absence of trading costs. With trading costs it could go both ways: an investor with a PnL bias that make them trade less than they would otherwise will be better off biased than unbiased.

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  2. I got here via a Barry Ritholtz link, and very happy I did. Great reminder of why I no longer trade, and very happy with returns and ease of my new investing life.

    Thanks for a well written piece.

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  3. Welcome back from wherever you were. Great stuff, especially "we blame the ... world for the mistakes of our minds."

    Now to some picky details. Barber and Odean's research ascribes overtrading to the self-attribution bias, illusion of knowledge and illusion of control, not to selling winners. Winners and loser were determined retropectively by the researchers, not the traders. What you mean to suggest is: Trade Less.

    All money is equal, but not all expenses. There are necessary expenses and discrenary ones. It is thoughtless mental accounts that are the problem.

    Financial experts have some roles: estate planning, navigating regulations. Just not fortune telling.

    Finally, telling readers not to get excited about money is like telling them not to get excited by what excites them. You know the research here. What is needed are practices. Practice waiting a few days to make any discretionary purchase. Limit trades to a particular day and/or number per week or better month. Apply procrasination strategies.

    Looking forward to more enticing entries from you.

    Charles

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