Retail Investor .org

EMOTIONS DESTROY INVESTING RETURNS


What can the retail investor do to minimize the damage caused by emotional investing? Since the tech crash the concepts of Behavioral Finance have been widely discussed. The research proves that investors make the same wrong emotional decisions predictably. It validates what was previously common sense - the best investors take their emotions out of the mix by developing strategic and application rules - rules they try hard to never break. Following, are some emotional errors investors make, and some ways to avoid them.

Lack of Perspective

Equity investing is risky. Market values swing widely up and down. Yet many investors, enticed into the market by a succession of good results, are surprised when prices fall. Before buying stocks you should review the historical returns (graph on Sheet 8). Know beforehand that 10% losses lasting a full calendar year are normal. Ask yourself how you would feel at the end of that year: REALLY. Sit quietly and pretend it is Dec31 and your investment losses equal (say) all your year's salary. How will you feel?

A 20% drop in price over a few months causes many investors to panic. They clog the discussion forums asking "Should I sell?" But a few months is nothing. What if you are still under water two years later? This is the reality of equity investing. Predict how you will react BEFORE you invest.

You will only really know your own tolerance from experience, so move into common stocks gradually over many years. Don't allow some advisor at the bank to tell you that your asset allocation should be such-and-such. Keep your GICs going, and put only incremental savings into common stocks gradually.

If you cannot handle it, you will have to save more money and invest in less risky debt. Or maybe you can offload your investing to someone beyond your reach, and beyond your view. What you cannot see or control will not upset you. (But take care who you chose.)

Magnify the Losses

You can control your perceptions of loss. The media will always measure a loss from the peak of the last market high. This makes it seem very large. But you can also measure a market drop by the length of time since the current level was last seen. For example, the tech crash only reversed a few year's worth of gains. Measuring only the downside will freak you out. But offsetting the losses against prior gains puts things into perspective.

Alternately you can measure your performance on a calendar year-to-date basis. At each year end you mentally close the books and move on. What happened, happened. When markets are falling through the year-end period, part of the losses will be thought of as 'last year's'. Only the losses since January are in your mind.

The reverse of this problem exists after you have lost a large percentage on a security. You are considering whether to sell or hold on because you see very little downside left. It is common in this case for investors to calculate the additional potential loss as a percent of the original purchase price. This downplays the potential loss. It should be calculated as a percent of today's market value. The past is 'sunk'. Only the future is considered in decisions.

Attention to Details

Never forget it is the performance of the portfolio, in total, that counts. You unnecessarily upset yourself by paying too close attention to the performance of individual stocks. All investors make some good calls and other bad ones. Make a decision to look at your portfolio TOTALS only. Yes you can review the news of all the stocks, but forbid yourself from tracking their price.

Too much attention can also mean tracking your portfolio weekly (or even daily). Forbid yourself. The more you think about it; the more you worry; the more you want to take action. Get on with your real life and trust your portfolio to do its work over time.

Are you the person who cannot take a vacation without continuing to track your portfolio? This may indicate two problems. Either you are just too obsessed (gambling addiction) or your choice of stocks is way too risky. There is nothing wrong with owning boring blue-chip companies. Notice that you own companies, not stocks. The stock market goes up and down. But steady companies just chug along. These allow you to take vacations.

Second Guessing Yourself

In order to ignore daily price fluctuations, you must have faith in your own ability to buy the stocks of good companies: companies that can withstand the ups and downs of the economy. There are two opposite ways to gain this faith. First, you can do your own comprehensive research and analysis. It is your ego that sooths you with "don't worry what the market thinks, I know this is a good company".

You cannot get your ego engaged by buying stocks recommended in the media or on discussion forums. Never buy a stock "because JoeBlow said it is a good buy". You need a reason to not worry when its price falls. Your own analysis gives you that reason. You should only consider selling when your analysis has been proved wrong.

Second, it is easier to stick with a falling stock, and not regret selling a rising stock, if your decisions are less subjective. Develop rules for stock selection that you do not break. If the rule is defensible, it will give you backbone when an individual stock behaves differently. You will be able to say "that's ok, the rule will work in the long-term".

Seller's remorse is the same for stocks as it is for real estate. If a stock you sold drops in price there is only a minor sense of validation. But if the stock rises, you berate yourself with the lost opportunity - coulda, woulda, shoulda. Since there is no upside, forbid yourself from checking its price after you sell. Only revisit the stock after a few month's cooling off. Don't go looking for grief.

Opportunity Lost Envy

Every analysis finds that retail investors who trade frequently have lower returns. So how do you prevent yourself from trading? One emotional trigger is caused by the investor continuing to look at other stocks, even after his portfolio is created. There will always be stocks doing better than what he currently owns. From envy he concludes he should switch. This is the wrong conclusion. Different stocks make moves at different times. Short term comparisons are meaningless.

Control yourself by NOT looking at other possible purchases, until after you have sold a current holding. Without the erroneous comparison, you will be benchmarking your current holdings against the broad market indexes: a much better comparison: a much less volatile comparison.

Falling in Love with your Stocks

The longer you own a stock the greater your emotional attachment to it. This happens to everyone. The problem is augmented when it originally performed very well. The 'sell' decision is very hard. When the stock is falling you ask yourself whether there really is a problem, or if you should ride out the volatility. When the stock is still rising you want to milk it for all it's worth. Loving a stock predisposes you to find excuses, downplay problems, and throw valuation to the wind.

There is no easy fix for this problem. One debatable solution is to use "stop-loss orders". Certainly this removes the sell decision from all emotion. But it also removes it from a rational analysis. It may save you from more downside. But it may also lock-in your losses just before the stock turns around.

"I just want to get my money back."

Most investors hate to sell at a loss. It crystallizes your error forever. We value a $2 gain less than we hate a $2 loss. So what do you we do? We hold, and hold, and hold, in the hopes the stock will eventually get back to our purchase price - so we can breakeven.

But your objective is never "to break even". It is always "to make a profit". All the time your money was tied up in that loser stock, it could have been earning income somewhere else. There is a 'time value of money', or an 'opportunity cost' to letting it sit unproductive.

One way to overcome this instinct is to replace the 'buy-sell-hold' paradigm with 'buy-sell'. It makes no sense to say "hold if you already own it, but don't buy if you don't". It is either a good investment FROM THIS POINT FORWARD, or it is not. All investing decisions consider only the future. The past is irrelevant. What you originally paid for the stock is irrelevant. You should only hold a stock when you would willingly buy it as a new purchase.

That said, there are two valid excuses for considering a 'hold if you already own'. Transaction costs used to be in the hundreds of dollars. Since any decision to sell really involves the subsequent purchase as well, these costs could add up. But today, trades cost only $10, and transactions costs should not be an excuse for inaction. Taxes must also be considered. If a loss is crystalized there will rarely be a problem, but when the sale triggers a capital gain, that cost may make 'holding' a better decision. Make sure you do the math. This was discussed previously in Why Make Your Own Decisions.

Another strategy to control this emotion is to structure your portfolio monitoring. Only look at your personal data periodically. In the interim use screen displays that show only the market information. This is the information you should use for buy/sell decisions. See the discussion at Keep Track.

A more debatable strategy is to buy stocks with borrowed money. The point is to make the 'opportunity cost' real and tangible. You would be punished (with losses) if you don't make your investments work for you all the time. You no longer have the luxury of waiting.

Be clear that this is not to say you should sell all your stocks that decline in price. If there is a good business, and the market is undervaluing the stock, then you may well conclude that the opportunity FROM THIS POINT FORWARD is better than it was before the stock's drop. You may be wrong, but you will have made the decision correctly.

Listening to Noise

Breaking news can raise your blood pressure, cause excessive trading, and turn you into a bandwagon jumper. Actively avoid it. Turn off the TV and read the back issues of the paper on the weekend. Do you really think that you will save yourself from disaster, by hourly monitoring the news? Sorry, but the stock will have moved within the quarter-hour.

Confusing Entertainment for Advice

E.g. Phone-In Shows. It is a sad state of affairs that the media must still warn investors, on every show, to "do your own research"...even while it is clear that most won't. The value of the expert's public opinion can be judged when they are asked hard, specific questions. Most refuse to answer and change the subject. The opinions they give can be classified under three categories. You must be clear in your mind which is being discussed.

  • The stock: its valuation and the chart indicators. Remember, you only make money when the stock (not the company) does well. It could be argued that every company, no matter how bad, would be a good buy at SOME price.
  • The company fundamentals. Don't assume that a good company should be bought at ANY price.
  • "The Story". This is the 'hook' that gets you interested. Very, very often there is next to no substance behind the story. So many people repeat it, it gets a life of its own. It can also drive the stock over the short run. But you MUST, MUST, MUST make sure the financials support its reality.

E.g. Analysts' Recommendations. Back-testing of portfolio performance has shown better results for stocks with 'sell' recommendations, than with 'buy's.
E.g. You can back test the recommendations using ROBTV's data. Randomly choose recommendations from the last week of January 2005, and remove the income trusts because of dividends. Compare those returns to the XIU-T index return. The four (Zechner, Grandich, Tomka and Callander) experts' returns averaged 18%. The index averaged 32%. None of the experts did better than the index.