Humans Are Built to Be Bad Investors

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Published February 2, 2018


This week we offer a post on the psychology of investing from Urban Carmel’s blog. The emotional challenges presented here are a major reason why we at TimingCube strongly prefer our quantitative models that REMOVE the emotion from our investing decisions. Here is Urban Carmel’s post:

Summary: Too often, investors sell their winners early and hold on to their losers in order to avoid taking a loss. Put another way, when faced with a gain, investors avoid risk; when faced with a loss, they seek risk. It’s the exact opposite of what a rational, profit-maximizing investor would be expected to do. This is another paradox of human behavior that helps explain why most investors perform badly.

Why do investors act in this way and how can this behavior be avoided?

* * *

Prominent, but rare, events are often mistakenly ascribed a high likelihood. Bear markets and crashes are objectively uncommon but feature prominently in our decision making. They stick with us. As a result, the average investor earns a return that is barely higher than the annual rate of inflation.

To make matters worse, active investors engage in risk at exactly the wrong time, and avoid risk when they should instead be taking it. For example, many investors waited years after the financial crisis before wading back into the stock market thereby missing out on a substantial chunk of the market’s recovery gains.

Imagine you are given the choice between:

a. $1 million guaranteed, or
b. A 50/50 chance to receive either $2 million or zero.

The expected payoff of both options is the same, but most individuals choose a guarantee of $1 million (option a) rather than a chance to win $2 million. When faced with a gain, risk is avoided.

Now imagine you are given the choice between:

c. A certain loss of $1 million, or
d. A 50/50 chance of losing $2 million or losing nothing.

The expected payoff is once again the same for both options, but this time most individuals avoid the guaranteed loss and favor gambling in order to breakeven (option d). When faced with a loss, risk is preferred (see note at the bottom of this page).

These two scenarios are similar to those faced by investors every week. Buy a stock and the price runs up. Investors will often seek to lock in their gains, foregoing further potential for profit, as in the first scenario. They avoid risk. That old Wall Street saw is “no one ever went broke taking profits.”

But if the stock price gaps down and they face an unexpected loss, investors’ behavior flips: suddenly, they favor risk-taking in order to get back to breakeven, as in the second scenario. When faced with a painful loss, investors seek risk.

Like overweighting the likelihood of rare events, this is another paradox of human behavior that helps explain why most investors perform badly. When faced with a gain, they avoid risk; but when faced with a loss, they seek risk. It’s the exact opposite of what a rational, profit-maximizing investor would be expected to do.

Experienced investors will recognize this trait (in themselves, if they are being honest): they too often sell their winners early and hold on to their losers in the hopes they will avoid the psychological pain of a loss. Over time, the gains from a number of modest winners are offset by a few big losers. Overall performance is disappointing.

Why do investors act in this way?

Humans are pleasure maximizing animals. Selling with even a slight gain provides an immediate reward and gratification. Holding on to losers postpones the disappointment of failure.

Moreover, investors’ decisions are often as much about avoiding feeling regret as they are about making money. The regret of accepting a certain loss when there is a possibility of getting back to break even makes risk-seeking more attractive. Likewise, the regret of ending up with nothing instead of a guaranteed $1 million makes risk-avoidance more attractive. Regret – nothing more than an emotion – heavily influences our decisions about when to take risk.

Michael Lewis wrote about regret in “The Undoing Project”, noting that “people did not seek to avoid other emotions with the same energy they sought to avoid regret.” He notes that the emotion is so strong that in a study of Olympic medalists, bronze medalists were judged to be happier than silver medalists. “The silver medalists dealt with the regret of not having won gold, while bronze medalists were just happy to be on the podium.” By selling winning stocks too early, investors are willingly paying a fee (a “regret premium”) to avoid feeling regret if the price falls.

The regret premium is not small, either. Investors will continue to prefer gambling in order to avoid a certain loss even when that loss is cut in half. In other words, they accept risk with a strong negative expected value. This is the same psychological phenomenon that makes casinos and lotteries profitable.

So, how can investors avoid making these mistakes?

Investors can remove emotions from their decision making. One effective strategy is to enter exit conditions at the time of entry. If the prices rises, the stop-loss is raised; winners are allowed to run, the impulse to seek gratification is delayed. If price falls, the sell order is executed; risk is clearly defined, the regret premium is eliminated. In this way, the decision to sell is made before emotions like pleasure, disappointment and regret can be experienced.

Strict rules-based investing is simple in concept but often difficult in practice. However, bad investment decisions very often result from allowing our emotions to over rule the basic mechanics that guide risk/reward.

Here at TimingCube there is never any emotional override of our models. They have served us well and we sleep much better knowing they will take care of our wealth. If you want to sleep even better, consider our FP Research Multi-Asset portfolio. This model portfolio expands our TimingCube methodology to a wider range of stock market and bond sectors, thus providing substantial diversification along with independent timing models on many of the market’s major sectors.

Market Update

After a historic run, investors were reminded this week that stocks can indeed go down. Concerns about Apple’s new iPhone X pressured the market’s largest company Monday pushing the stock down -2% on the day and handing the broader market a -0.7% dip. Tuesday brought a second day of losses (-1.1%) with the announcement of a new company focused on reducing health care costs punishing the health sector. The new company is being formed as a partnership between three of the country’s most powerful companies – JP Morgan (JPM), Amazon (AMZN), and Warren Buffett’s Berkshire Hathaway (BRK.B). While the focus is on reducing the cost of care for their many employees, the market took the news as a broadside attack on the profit margin in certain very rich areas of the healthcare market. Energy shares also came under pressure as crude oil prices fell back. The two-session losing streak came to a halt Wednesday, but only just so as stocks turned in a flat performance. Stocks actually had broken higher in the morning and were up solidly until the release of the Federal Reserve’s meeting statement. Fed officials acknowledged strength in labor markets, inflation, and economic growth. While none of that is surprising, the tone of the statement was viewed as confirming the upward bias in interest rates. Healthcare stocks added to their Tuesday slide in Wednesday’s trade. With a very solid month of January now in the books, investors kicked off February’s trade Thursday with interest rates rising sharply. (The 10-year U.S. Treasury yield has moved from 2.40% to 2.85% so far in 2018.) The headwind of sharply rising interest rates kept stocks in check Thursday despite strong earnings from a representative swath of companies. Consumer/tech powerhouses Microsoft (MSFT) and Facebook (FB), industrial giant DowDupont (DWDP), delivery company UPS, and media/communications behemoth AT&T (T) all beat earnings and revenue estimates. Yet only two of those companies saw a positive market reaction to their beats, an indication of the change in tone this week as the broad market posted a flat result on the day. Stocks really lost it Friday with market indexes falling -2% in a proverbial 9-to-1 negative day – e.g. a day where 9 stocks are down for every 1 that is up; thus, an extremely negative skew to the market. On the earnings front, Amazon (AMZN), Apple (AAPL), and Visa (V) all beat earnings with only Amazon holding a gain at day’s end. Oil giants Chevron (CVX) and Exxon (XOM) took the air out of the energy stock sector by missing revenue estimates in their reports leading to a battering in their shares (the energy sector fell -4% on the day). Facilitating the selloff was another rip higher in interest rates. This time, the monthly employment report provided the spooks. Wages, the biggest driver of inflation, were shown to have risen solidly in the report, gaining almost +3% over the prior year. This wage number was viewed as justifying the market’s interest rate push, causing investors to take some money out of stocks after their January run up.

In the 24 months since the kickoff of the current market rally, the S&P 500 has only had ONE losing month. Just ONE! One loser out of 24 months. The first week of February started the month solidly in the hole. For the week, which included the last three days of January also, the S&P 500 (SPY) dumped -3.88%. The Nasdaq 100 (QQQ) tumbled -3.70%. Small-caps (IWM), though badly lagging the market’s January rise, fell a similar -3.62%

Warm wishes and until next week.