Monday, October 30, 2017

Investor Psychology, Part III: Seeking and Avoiding Risk At Exactly The Wrong Time

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?

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In a recent post, we described how prominent, but rare, events are mistakenly ascribed a high likelihood. Bear markets and crashes are objectively uncommon but feature prominently in our decision making. As a result, the average investor earns a return that is barely higher than the annual rate of inflation (that post is here).

To make matters worse, active investors engage in risk at exactly the wrong time, and avoid risk when they should instead be taking it.

 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 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?

Lewis describes how physicians can detail the criteria they use to make medical diagnoses. In practice, physicians deviate from this criteria; they make mental errors and poorer decisions. A simple but unemotional algorithm created from physicians' own criteria avoids these errors and makes better decisions.

Investors can, likewise, 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.

Recognizing how and why we make errors in our decision making is an important first step to making better decisions in the future.

Note: A version of this paradox was originally presented by the French economist, Maurice Allais. It was then modified by two Israeli psychologists, Amos Tversky and Daniel Kahneman, whose work formed the foundation of behavioral economics. After Tversky died, Kahneman received a Nobel in economics.

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