4 Mental Traps That Can Ruin Your Investment Returns – Low Cost Advisor
While investors have always struggled with the crucial issue of timing their buys and sells, it’s perhaps never been as true as it is now. Between cryptocurrencies, such as Bitcoin and the even more ridiculous Dogecoin, and meme stocks, like GameStop and Clover Health, investors are very much risk-on. The thousands they received in stimulus checks and the run-up in home prices only added to their confidence.
The only problem is this rush of confidence hasn’t done anything to change the fundamental fact that the vast majority of humans are horrible when it comes to trading: We sell when we should buy, buy when we should sell and are overly influenced by the noise around us.
Consider one simple stat: For the seventh consecutive year, a majority of U.S. active fund equity managers (that is experts who pick stocks for a living, not just run-of-the-mill Redditers) underperformed their benchmark index, according to the S&P Index Versus Active (SPIVA) Scorecard. That means you would have whooped most of the professional monied 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 when they’re wrong. For investors, this trait can rear its ugly head in something called the disposition effect, which is the inclination to sell winners too quickly and hold on to losers too long.
The bias was first described by Hersh Shefrin and Meir Statman in 1985 with their aptly named paper, “The Disposition to Sell Winners Too Early and Ride Losers Too Long,” which built off the work done by psychologists Amos Tversky and Daniel Kahneman, among others.
What’s going on? Well, Shefrin and Statman lay out a few reasons:
1. Prospect Theory
‘This was Tversky’s and Kahneman’s big breakthrough and it’s perhaps best exemplified by an example used by Shefrin and Statman:
You bought $50 worth of stock a month ago that’s now worth $40. You need to decide what to do: keep the stock or sell. Let’s assume that there’s an equally good chance that the stock will increase by $10 in a month or drop another $10. Tossing out tax or transaction cost considerations, what would you do—sell the stock and make the $10 loss permanent, or hold on and see if you can win the 50/50 bet to get back even?
Prospect theory, which essentially posits that losing hurts more than winning feels good, suggests that you, and most investors, would rather double down than admit defeat and take the loss.
While prospect theory addresses a lot of the impulse to hold on to losers, thereby not accepting a loss, it does leave some holes. After all, what about tax-loss harvesting? This practice allows you to sell a loser, realize the loss and then use that to lower taxes on future gains. Plus, you can use the money from the sale to buy a related company that will likely deliver similar future returns (e.g., selling Ford to buy GM).
Tax-loss harvesting, then, gets around the issues raised by prospect theory because you’re taking the same gamble (that American car companies will sell a bunch of cars), while getting a good tax break. Why, then, do people tend to hold onto losers? Enter: mental accounting.
2. Mental Accounting
This bias, first described by economist Richard Thaler, explains that people making decisions tend to stash different types of gambles into different accounts in their heads that don’t interact. They then deal with each of those separate accounts through the lens of prospect theory.
If that sounds a little abstract, here’s how this might play out: When an investor buys Ford, they open up a new mental account and they, as prospect theory describes, don’t want to realize a loss on that account. While the future returns of Ford and GM might be the same, tax-loss harvesting would require one account to be closed with a loss, which just isn’t what people are inclined to do.
No one wants to admit to their friends that they picked a horse with a bum leg.
3. Regret Avoidance
Any country music fan can attest to the emotional impact of regret. By selling at a loss, you’re admitting that your judgment erred, and you’ll have to live with the shame. (And admit as much to the IRS.)
Take ExxonMobil. In 2007, the energy behemoth had a market cap of nearly $530 billion and was ranked second on the Fortune 500 list. Since then the company’s value has nearly halved as oil prices have generally declined and traditional oil and gas extractors have gone out of favor. Selling your stock over the past 14 years, though, would have required you admitting that you not only missed what was to come, but that you also weren’t able to take advantage of other high risers. So you hold on, hoping for a reversal.
On the other hand, if you sell a winner, well, you’ve won. You didn’t experience regret, but rather pride. Hence investors are more willing to take profits, perhaps even earlier than they should have, in an attempt to stave off potential losses.
4. Self Control
If these biases are well-known, you might ask, why are people not simply avoiding these pitfalls? If only it were that simple.
In a 1957 paper titled “A Social Psychology of Futures Trading,” researcher Ira Glick closely followed the behavior of a group of traders. They “were clearly aware that riding losers was not rational. Their problem was to exhibit self-control to close accounts at a loss, thereby limiting losses,” Shefrin and Statman note in their summary of Glick’s research.
To overcome this human trait, some traders use ironclad rules to force their action. For instance, selling a stock if it falls 10%. By cutting your losses quickly, you’re making it more likely that your portfolio will gain overall. Remember to recover from a 10% loss (going from $10 to $9, say), you’ll need that stock to jump 11% (to get back up to $10 from $9). Put yourself in the hole long enough, and you may never dig out.
Shefrin and Statman looked at a slew of data points from investor behavior over several years and learned that the evidence supported their theory: “We found that tax considerations alone cannot explain the observed patterns of loss and gain realization, and that the patterns are consistent with a combined effect of tax considerations and a disposition to sell winners and ride losers.”
A paper published more than a decade later by Terrance Odean did something similar: He looked through the brokerage accounts of 10,000 investors and found out that, yes indeed, investors sell appreciated securities too quickly and hold on to stock and those in the red too long.
“Their behavior does not appear to be motivated by a desire to rebalance portfolios, or to avoid the higher trading costs of low priced stocks,” noted Odean in a 1998 article in the Journal of Finance entitled “Are Investors Reluctant to Realize Their Losses?” “Nor is it justified by subsequent portfolio performance,” he found. “For taxable investments, it is suboptimal and leads to lower after-tax returns.”
What You Can Do to Outsmart Your Psychology
When you get into the business of making active trades, you open yourself up to any number of the above psychological mistakes.
“Evidence indicates that individual investors are not wise to buy or sell individual stocks because they lose the benefits of diversification,” said Statman, Santa Clara University professor of finance. “Moreover, if they are lucky, the traders on the other side of their trades are as ignorant as they are, and if not lucky, are ones with inside information. So individual investors are better off with broadly diversified low-cost index mutual funds or ETF.”
That sentiment was echoed by Dartmouth University economics professor Erzo Luttmer.
“My advice is not to try to predict or outsmart the market,” said Luttmer. “Hold a well-diversified portfolio using funds with low fees (e.g., index funds) and don’t react to market ups and downs. This is also what I do personally.”
If you don’t want to manage even the effort of picking index funds, you can opt for a robo-advisor that handles all investment portfolio decisions and maintenance for you. That way you don’t have to react to stock market news.
“I learned to shrug my shoulders when markets go up or down,” said Statman. “Wise financial behavior and good exercise.”