Behavioral Finance: Looking at the Way Your Thinking and Behavior Affects Your Investing
The study of Behavioral Finance helps us understand why we sometimes make choices that seem to be perfectly reasonable and rational, but somehow go wrong. The truth is that we all have biases and blind spots in our thinking that cause us to behave in ways that can be self-defeating. This series of posts explores several of the best-known behavioral problems when it comes to investing, as well as thoughts on how to overcome them.
Part 2 in a series of 5.
Last time, we took a look at the problems of Overconfidence and The Illusion of Knowledge. This time we’ll look at the next two behaviors: Fear of Regret and Seeking Pride, and Mental Accounting.
Problem: Fear of Regret and Seeking Pride
This problematic behavior is actually very easy to understand but very difficult to overcome. It is human nature to avoid situations that cause us pain or regret. On the other hand, it is also human nature to seek out situations that make us feel better about ourselves.
When it comes to investing, we do exactly the same things. When we purchase a stock, we do so with an expectation that it will rise in value, giving us a positive return. However, that does not always happen. Some stocks rise, others fall, some even collapse. When those investments fall and the owner is faced with a loss, most have a tendency to hang on to the stock in the hope of a turnaround. Many investors have been caught in this trap and held those losing stocks until they were simply worthless pieces of paper.
Just the opposite can be true when it comes to those stocks that are big winners. An investor that has a big winner, especially if it moves up very quickly, will have a tendency to sell the stock at the first sign of trouble in order to lock in the gains and show just how great an investment they made.
One of the problems with this kind of thinking is the impact of taxes upon a portfolio. If you sell a stock that has gained in value, you will pay taxes on that gain (retirement accounts excluded). That tax effectively reduces the amount of the gain. Conversely, if you sell a losing stock, you get a tax credit for the loss, and that tax credit actually reduces the amount of the loss. From a purely economic standpoint then, the old Wall Street axiom makes perfect sense: “Sell your losers and let your winners ride.” Unfortunately, in wanting to avoid the pain and regret of realizing a loss, many investors do exactly the opposite. This is known as the disposition effect, where investors appear to be predisposed toward selling their winners too early and holding their losers far too long.
Here is an example to help flesh this out a bit: Say an investor owns two stocks, A and B. Stock A was purchased for $850 and stock B for $1,250. Also assume that the capital gains tax rate is 20%. Time passes and the investor finds himself in need of $1,000 which he will take from this portfolio. He looks to see which stock to sell and finds that each of the two stocks is now worth exactly $1,000. Which one should he sell?
Selling stock A will yield a gain of $250, while selling stock B will yield a loss of $250. In both cases the investor would raise the $1,000 he needs. The disposition effect would predict that the investor would sell stock A instead of stock B so that he could avoid realizing the regret of the loss and capture the good feeling of having made a winning investment choice.
However, if taxes are factored into the picture, we see that stock A was definitely not the best economic choice. Selling stock A gives the investor a gain of $250, which triggers capital gains taxes of $50 for net after-tax proceeds of only $950. Selling stock B causes the investor to realize a loss of $250, but that capital loss provides him with a tax deduction that is worth $50. This equals net after-tax proceeds of $1,050, which is a much better choice.
The caveat here is that there may be other reasons to hold onto a losing position. One such reason might be if we know that the loss is indeed a temporary issue. Each investment must be viewed within the bounds of the long-term trend, and the riskiness or volatility inherent within that stock. In the end though, the axiom certainly does seem to be true: “Sell your losers and let your winners ride.”
Problem: Mental Accounting
While it may sound like some kind of memory game for CPA’s, mental accounting really has little to do with actual accounting. In fact, mental accounting is more closely related to the fear of regret and seeking pride. In mental accounting, the investor tends to place each investment into a separate, imaginary account. This is usually based upon the intended uses of the invested capital, the type of specific securities involved, or even the current status of the investment. For instance, an investor might set up one account for retirement savings, another for vacation savings, and another as a Christmas fund. The problem with this thinking is that it causes the investor to overlook the interactions between their investments.
In “The Psychology of Investing”, John Nofsinger again offers a good example of the outcome of this thinking:
Consider the wealth-maximizing strategy of a tax swap. A tax swap is when an investor sells a stock with losses and purchases a similar stock. For example, suppose you own Northwest Airlines stock, which has experienced a price decline along with the entire airline industry. You could sell the Northwest stock and purchase United Airlines stock. This tax swap allows you to capture the capital loss of Northwest stock to reduce your taxes while staying invested and waiting for the airline industry to rebound.
Why isn’t the tax swap strategy used more often? Investors tend to consider the selling of the loser stock as a closing of that mental account and the buying of the similar stock as the opening of a new mental account. This causes two outcomes that affect investors. First, the interaction between these two accounts increases the investor’s wealth. Second, the closing of the loser account causes regret. Investors tend to avoid the interaction between accounts; therefore, investors act to avoid regret instead of to maximize wealth.
This is just one example of this behavior, but it does demonstrate just how we need to be aware of the big picture as we view our financial holdings. This means seeing each account as a piece of the entire portfolio. Each piece plays its own role in meeting the goals of the portfolio as a whole - that is maximizing wealth while reducing risk. By focusing only on individual mental accounts, we lose track of that big picture and begin to make choices that we would not otherwise.
Fear of Regret and Seeking Pride and Mental Accounting are behaviors that occur when we lose sight of the big picture and allow emotions to cloud our judgment. Disciplined investing means that we set forth a course of action and follow those rules in spite of emotional distractions.
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