While investors have always grappled with the crucial question of the timing of their buy and sell, this has perhaps never been truer than it is today. Between cryptocurrencies, such as Bitcoin and the even more ridiculous Dogecoin, and memes stocks, like GameStop and Clover Health, investors are very risky. The thousands they received in stimulus checks and rising house prices only added to their confidence.
The only problem is that this surge of confidence has done nothing to change the basic fact that the vast majority of humans are horrible when it comes to negotiating: we sell when we should buy, buy when we should sell, and we are. too influenced by the noise around us.
Consider a simple statistic: For the seventh year in a row, a majority of active U.S. fund equity managers (i.e., experts who choose stocks for a living, not just ordinary redeemers) have under -performed their benchmark, according to the S&P Index Versus Active (SPIVA) scorecard. This means that you would have recovered most of the professional money class simply by buying an exchange traded fund (ETF) that tracked an index.
Why does this happen so frequently? Look no further than our human nature.
Why humans make bad traders
No one likes to admit they are wrong. For investors, this trait can show up in what is called the disposition effect, which is the tendency to sell the winners too quickly and keep the losers too long.
The bias was first described by Hersh Shefrin and Meir Statman in 1985 with their aptly named article, “The Disposition to Sell Winners Too Early and Ride Losers Too Long,” which draws on work done by psychologists. Amos Tversky and Daniel Kahneman, among others. .
What is happening? Well, Shefrin and Statman outline a few reasons:
1. Theory of perspectives
âThis was the big breakthrough of Tversky and Kahneman and it is perhaps best illustrated by an example used by Shefrin and Statman:
A month ago you bought $ 50 worth of stocks which are now worth $ 40. You have to decide what to do: keep the stock or sell. Suppose there is an equally good chance that the stock will go up $ 10 in a month, or go down another $ 10. Regardless of taxes or transaction costs, what would you do: sell the stock and make the $ 10 loss permanent, or wait and see if you can win the 50/50 bet for revenge?
Outlook Theory, which essentially postulates that losing hurts more than winning does good, suggests that you, and most investors, would rather double up than admit defeat and suffer loss.
While outlook theory addresses much of the impulse to hang on to losers, thus not accepting a loss, it leaves a few holes. After all, what about harvesting tax losses? This practice allows you to sell a loser, realize the loss, and then use it to reduce taxes on future winnings. Additionally, you can use the money from the sale to buy a related business that will likely offer similar future returns (for example, selling Ford to buy GM).
Harvesting tax losses therefore circumvents the issues raised by outlook theory because you are making the same bet (that American automakers will sell a bunch of cars), while getting a good tax break. Why, then, do people tend to hold on to losers? Enter: mental accounting.
2. Mental accounting
This bias, first described by economist Richard Thaler, explains that people who make decisions tend to store different types of bets in different accounts in their heads that do not interact. They then deal with each of these separate accounts through the lens of perspective theory.
If that sounds a bit abstract, here’s how it might play out: When an investor buys Ford, they open a new mental account, and as outlook theory describes, they don’t want to make a loss on that account. While future returns for Ford and GM might be the same, harvesting tax losses would require closing an account with a loss, which is just not what people are inclined to do.
No one wants to admit to their friends that they have chosen a horse with a hind leg.
3. Avoid regrets
Any country music fan can testify to the emotional impact of regret. By selling at a loss, you recognize that your judgment was wrong and you will have to live with shame. (And admit it to the IRS.)
Take ExxonMobil. In 2007, the energy giant had a market capitalization of nearly $ 530 billion and was ranked second on the Fortune 500 list. Since then, the company’s value has almost halved as oil prices rise. generally declined and traditional oil and gas extractors fell into disuse. Selling your shares for the past 14 years, however, would have forced you to admit that not only did you miss what was to come, but you weren’t able to take advantage of the other skyscrapers either. So you hold on, hoping for a turnaround.
On the other hand, if you sell a winner, well, you’ve won. You didn’t feel regret, but rather pride. As a result, investors are more willing to take profits, perhaps even sooner than they should, in an attempt to avoid potential losses.
If these biases are well known, you might ask yourself why don’t people just avoid these pitfalls? If only it was that easy.
In a 1957 article titled âA Social Psychology of Futures Trading,â researcher Ira Glick closely followed the behavior of a group of traders. They âwere clearly aware that riding losers was not rational. Their problem was to use self-control to close loss-making accounts, thereby limiting losses, ânote Shefrin and Statman in their summary of Glick’s research.
To overcome this human trait, some traders use bulletproof rules to force their action. For example, selling a stock if it drops 10%. By reducing your losses quickly, you increase the likelihood that your portfolio will win overall. Remember to recover from a 10% loss (going from $ 10 to $ 9, say), you will need that stock to jump 11% (back to $ 10 from $ 9). Put yourself in the hole long enough and you will never be able to dig it.
Shefrin and Statman examined a large number of data points on investor behavior over several years and learned that the evidence supported their theory: âWe have found that tax considerations alone cannot explain the observed patterns of realization. gains and losses, and that models a combined effect of tax considerations and a willingness to sell winners and losers.
An article published more than a decade later by Terrance Odean did something similar: he examined the brokerage accounts of 10,000 investors and found that, yes indeed, investors sell valued securities too quickly and keep stocks and those in the red for too long. .
âTheir behavior does not appear to be driven by a desire to rebalance portfolios or avoid the higher costs of trading low-priced stocks,â Odean noted in a 1998 Journal of Finance article titled âInvestors Are- are they reluctant to realize their losses? “It is also not justified by the subsequent performance of the portfolio,” he found. “For taxable investments, it is sub-optimal and results in lower after-tax returns.”
What you can do to outsmart your psychology
When you start active trading, you expose yourself to a number of the above psychological mistakes.
âThe evidence indicates that individual investors are not wise to buy or sell individual stocks because they lose the benefits of diversification,â said Statman, professor of finance at the University of Santa Clara. âPlus, if they’re lucky, traders on the other side of their trades are as ignorant as they are, and if they’re unlucky, they have inside information. Individual investors are therefore better off with broadly diversified low-cost index mutual funds or ETFs.
This sentiment was echoed by Dartmouth University economics professor Erzo Luttmer.
âMy advice is not to try to predict or outsmart the market,â Luttmer said. âMaintain a well-diversified portfolio using funds with low fees (eg index funds) and not react to market fluctuations. This is also what I do personally.
If you don’t even want to manage the effort of index fund selection, you can opt for a robo-advisor who handles all the decisions and maintenance of the investment portfolio for you. So you don’t have to react to stock market news.
âI’ve learned to shrug my shoulders when the markets go up or down,â Statman said. “Wise financial behavior and good exercise.”