| Free Article |
Don't Shoot Yourself in the Foot with Emotional Errors
by Dave Van Knapp, author of
SENSIBLE STOCK INVESTING:
How to Pick, Value, and Manage Stocks
and
THE TOP 40 DIVIDEND STOCKS FOR 2010:
How to Generate Wealth or Income from Dividend Stocks
June, 2007
Classic economic theory posits that investors always behave perfectly rationally,
in their own best interests. Emotions are not involved. You may be thinking,
“That contradicts all my common observations and experiences in life,” and you
would be right. Nevertheless, classical economic theory is based on a world full
of rational, informed, iron-willed, self-interested, consistent, and efficient actors.
Behaviorial finance, on the other hand, recognizes the obvious: That investors
are often influenced by emotion, and that therefore they make illogical,
inconsistent, and ill-informed decisions, despite their best intentions to act in
their own self-interest.
There have been lots of studies in behavioral finance since the field took off
about 30 years ago. The studies—almost astonishing in their variety—have
attempted to find out how most people really act when making financial
decisions.
It turns out that we humans have several tendencies that don’t help very much
when we are investing. They skew our judgment. Here are the most common
traits that lead to investor self-sabotage:
--Failing to realize that the loss of an “unbooked” gain is a loss at all. Some
investors only think it is a loss if the account falls below what they originally
invested. They view an intermediate gain as not real, sort of like playing with
house money.
--Failing to book a loss on a hopeless investment, hoping that it will come back.
This is called loss aversion—people do not want to admit having made a
mistaken investment. Apparently, people feel more pain from a loss than joy at
an equivalent gain. They want to avoid regret over the loss—so they just don’t
book it.
--Failing to take on enough risk, and thus investing too conservatively. Over
many years, the most conservative investments (such as cash and bonds) do not
keep up with inflation. Thus ironically what seems most conservative actually
bears more risk: the loss of purchasing power to inflation as the years pass by.
--Not accepting a loss as the sunk cost it really is. This “sunk cost fallacy”
keeps you focused on the past and diverts attention from what you can do now
to get better results in the future.
--Selling winners too soon (to lock in profits, thus creating a feeling of victory),
but holding losers too long (waiting for them to get back to even so that there is
no loss to regret).
--Forgetting that the real goal of investing is to build wealth as effectively as
possible, rather than to justify the decisions you’ve made that got you where
you are right now. This can lead you to fail to evaluate your current investments
on their potential to produce gains from this point forward, rather than focusing
on the past.
--Becoming paralyzed by too many options. This inability to make “choice
under conflict” leads to taking no action at all when action is called for.
--Resigned acceptance of the status quo.
--Ignoring long-run “background odds” in the face of more immediate or
newsworthy information. For investors, the important background trend is that
the stock market has returned an average of 10% to 11% since before the Great
Depression. That’s more than twice as much as the bond market.
--"Preferential bias": The difficulty in changing an opinion about something once
an opinion has been formed, even if the opinion is only subconscious. This
causes incoming data to be processed selectively, with supportive information
being favored and contradictory information downplayed or even ignored. The
end result is reduced objectivity.
Obviously, an investor who is subject to any or all of the foregoing traits cannot
be totally rational, even if he or she is trying to be.
The Sensible Stock Investor needs to be as rational as possible, because over
time, the stock market tends to reward rational decisions. That is, the market
tends to move stocks towards their intrinsic values. For example, if you paid too
much for a stock, over time the market will reduce your returns from that stock
or even turn them into actual losses as it brings the price of the stock back to
what it is really worth. Regretting the loss, failing to accept the sunk cost,
holding onto the loser too long, failing to look ahead rather then back, and/or
resigned acceptance of the status quo obviously do not help you make the best
decision in this situation.
Fortunately, we humans can counteract some of our psychological tendencies
by using the left side of our brain with the aid of smart tools and processes
when we are making investment decisions. Such tools and processes would
include:
• A standard system for evaluating whether a company is a good company
• Calculating a well reasoned number as a favorable price for its stock
• Resolving never to make snap judgments on fragments of information or
hot tips
• Writing out your investment goals
• Taking into account your unique situation, including honestly assessing
your appetite for risk
• Choosing a strategy that is likely to lead to achieving your goals without
making you uncomfortable
• Making, periodically updating, and using a “shopping list” of investments
that meet your criteria; and
• Systematically reviewing your holdings with an eye to the future.
In the end, you want to apply your intelligence and objectivity to overcome self-
defeating emotional tendencies in your investing. Left-brain-based systems and
processes can help you to do that.
by Dave Van Knapp, author of
SENSIBLE STOCK INVESTING:
How to Pick, Value, and Manage Stocks
and
THE TOP 40 DIVIDEND STOCKS FOR 2010:
How to Generate Wealth or Income from Dividend Stocks
June, 2007
Classic economic theory posits that investors always behave perfectly rationally,
in their own best interests. Emotions are not involved. You may be thinking,
“That contradicts all my common observations and experiences in life,” and you
would be right. Nevertheless, classical economic theory is based on a world full
of rational, informed, iron-willed, self-interested, consistent, and efficient actors.
Behaviorial finance, on the other hand, recognizes the obvious: That investors
are often influenced by emotion, and that therefore they make illogical,
inconsistent, and ill-informed decisions, despite their best intentions to act in
their own self-interest.
There have been lots of studies in behavioral finance since the field took off
about 30 years ago. The studies—almost astonishing in their variety—have
attempted to find out how most people really act when making financial
decisions.
It turns out that we humans have several tendencies that don’t help very much
when we are investing. They skew our judgment. Here are the most common
traits that lead to investor self-sabotage:
--Failing to realize that the loss of an “unbooked” gain is a loss at all. Some
investors only think it is a loss if the account falls below what they originally
invested. They view an intermediate gain as not real, sort of like playing with
house money.
--Failing to book a loss on a hopeless investment, hoping that it will come back.
This is called loss aversion—people do not want to admit having made a
mistaken investment. Apparently, people feel more pain from a loss than joy at
an equivalent gain. They want to avoid regret over the loss—so they just don’t
book it.
--Failing to take on enough risk, and thus investing too conservatively. Over
many years, the most conservative investments (such as cash and bonds) do not
keep up with inflation. Thus ironically what seems most conservative actually
bears more risk: the loss of purchasing power to inflation as the years pass by.
--Not accepting a loss as the sunk cost it really is. This “sunk cost fallacy”
keeps you focused on the past and diverts attention from what you can do now
to get better results in the future.
--Selling winners too soon (to lock in profits, thus creating a feeling of victory),
but holding losers too long (waiting for them to get back to even so that there is
no loss to regret).
--Forgetting that the real goal of investing is to build wealth as effectively as
possible, rather than to justify the decisions you’ve made that got you where
you are right now. This can lead you to fail to evaluate your current investments
on their potential to produce gains from this point forward, rather than focusing
on the past.
--Becoming paralyzed by too many options. This inability to make “choice
under conflict” leads to taking no action at all when action is called for.
--Resigned acceptance of the status quo.
--Ignoring long-run “background odds” in the face of more immediate or
newsworthy information. For investors, the important background trend is that
the stock market has returned an average of 10% to 11% since before the Great
Depression. That’s more than twice as much as the bond market.
--"Preferential bias": The difficulty in changing an opinion about something once
an opinion has been formed, even if the opinion is only subconscious. This
causes incoming data to be processed selectively, with supportive information
being favored and contradictory information downplayed or even ignored. The
end result is reduced objectivity.
Obviously, an investor who is subject to any or all of the foregoing traits cannot
be totally rational, even if he or she is trying to be.
The Sensible Stock Investor needs to be as rational as possible, because over
time, the stock market tends to reward rational decisions. That is, the market
tends to move stocks towards their intrinsic values. For example, if you paid too
much for a stock, over time the market will reduce your returns from that stock
or even turn them into actual losses as it brings the price of the stock back to
what it is really worth. Regretting the loss, failing to accept the sunk cost,
holding onto the loser too long, failing to look ahead rather then back, and/or
resigned acceptance of the status quo obviously do not help you make the best
decision in this situation.
Fortunately, we humans can counteract some of our psychological tendencies
by using the left side of our brain with the aid of smart tools and processes
when we are making investment decisions. Such tools and processes would
include:
• A standard system for evaluating whether a company is a good company
• Calculating a well reasoned number as a favorable price for its stock
• Resolving never to make snap judgments on fragments of information or
hot tips
• Writing out your investment goals
• Taking into account your unique situation, including honestly assessing
your appetite for risk
• Choosing a strategy that is likely to lead to achieving your goals without
making you uncomfortable
• Making, periodically updating, and using a “shopping list” of investments
that meet your criteria; and
• Systematically reviewing your holdings with an eye to the future.
In the end, you want to apply your intelligence and objectivity to overcome self-
defeating emotional tendencies in your investing. Left-brain-based systems and
processes can help you to do that.
| SENSIBLESTOCKS .COM |
| Dedicated to the success of the individual investor |
| ||||||||||
| Click on either cover image to learn more about that product |