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Course 507
Behavioral Pitfalls, Part 1

Introduction

Successful investing is hard, but it doesn't require genius. In fact, Warren Buffett asserted that it's not so much raw brain power you need, but temperament "to control the urges that get other people into trouble in investing."

As much as anything else, successful investing requires something perhaps even more rare: the ability to identify and overcome one's own psychological weaknesses.

Over the past several decades, psychology has permeated our culture in many ways. In more recent times, its influences have taken hold in the field of behavioral finance, spawning an array of academic papers and learned tomes that attempt to explain why people make financial decisions that are contrary to their own interests.

Experts in the field of behavioral finance have a lot to offer in terms of understanding psychology and the behaviors of investors, particularly the mistakes that they make. Much of the field attempts to extrapolate larger, macro trends of influence, such as how human behavior might move the market.

This course and Portfolio 508 will focus on how the insights from the field of behavioral finance can benefit individual investors – specifically, how investors can learn to spot and correct investing mistakes in order to yield greater profits.

Pitfall: Overconfidence

Overconfidence refers to our boundless ability as human beings to think that we're smarter or more capable than we really are. It's what leads 82% of people to say that they are in the top 30% of safe drivers, for example. Moreover, when people say that they're 90% sure of something, studies show that they're right only about 70% of the time. Such optimism isn't always bad. Certainly we'd have a difficult time dealing with life's many setbacks if we were die-hard pessimists.

However, overconfidence hurts us as investors when we believe that we're better able to spot the next great investment than another investor is. Odds are, we're not. (Nothing personal.)

Studies show that overconfident investors trade more rapidly because they think they know more than the person on the other side of the trade. Trading rapidly costs plenty, and rarely rewards the effort. We'll repeat yet again that trading costs in the form of commissions, taxes, and losses on the bid-ask spread have been shown to be a serious damper on annualized returns. These frictional costs will always drag returns down.

One of the things that drives rapid trading, in addition to overconfidence in our abilities, is the illusion of control. Greater participation in our investments can make us feel more in control of our finances, but there is a degree to which too much involvement can be detrimental, as studies of rapid trading have demonstrated.

Pitfall: Selective Memory

Another danger that overconfident behavior might lead to is selective memory. Few of us want to remember a painful event or experience in the past, particularly one that was of our own doing. In terms of investments, we certainly don't want to remember those stock calls that we missed much less those that proved to be mistakes that ended in losses.

The more confident we are, the more such memories threaten our self-image. How can we be such good investors if we made those mistakes in the past? Instead of remembering the past accurately, in fact, we will remember it selectively so that it suits our needs and preserves our self-image.

Incorporating information in this way is a form of correcting for cognitive dissonance, a well-known theory in psychology. Cognitive dissonance posits that we are uncomfortable holding two seemingly disparate ideas, opinions, beliefs, attitudes, or in this case, behaviors, at once, and our psyche will somehow need to correct for this.

Correcting for a poor investment choice of the past, particularly if we see ourselves as skilled traders now, warrants selectively adjusting our memory of that poor investment choice. "Perhaps it really wasn't such a bad decision selling that stock?" Or, "Perhaps we didn't lose as much money as we thought?" Over time our memory of the event will likely not be accurate but will be well integrated into a whole picture of how we need to see ourselves.

Another type of selective memory is representativeness, which is a mental shortcut that causes us to give too much weight to recent evidence--such as short-term performance numbers--and too little weight to the evidence from the more distant past. As a result, we'll give too little weight to the real odds of an event happening.

Pitfall: Self-Handicapping

Researchers have also observed a behavior that could be considered the opposite of overconfidence. Self-handicapping bias occurs when we try to explain any possible future poor performance with a reason that may or may not be true.

An example of self-handicapping is when we say we're not feeling good prior to a presentation, so if the presentation doesn't go well, we'll have an explanation. Or it's when we confess to our ankle being sore just before running on the field for a big game. If we don't quite play well, maybe it's because our ankle was hurting.

As investors, we may also succumb to self-handicapping, perhaps by admitting that we didn't spend as much time researching a stock as we normally had done in the past, just in case the investment doesn't turn out quite as well as expected. Both overconfidence and self-handicapping behaviors are common among investors, but they aren't the only negative tendencies that can impact our overall investing success.

Pitfall: Loss Aversion

It's no secret, for example, that many investors will focus obsessively on one investment that's losing money, even if the rest of their portfolio is in the black. This behavior is called loss aversion.

Investors have been shown to be more likely to sell winning stocks in an effort to "take some profits," while at the same time not wanting to accept defeat in the case of the losers. Philip Fisher wrote in his excellent book Common Stocks and Uncommon Profits that, "More money has probably been lost by investors holding a stock they really did not want until they could 'at least come out even' than from any other single reason."

Regret also comes into play with loss aversion. It may lead us to be unable to distinguish between a bad decision and a bad outcome. We regret a bad outcome, such as a stretch of weak performance from a given stock, even if we chose the investment for all the right reasons. In this case, regret can lead us to make a bad sell decision, such as selling a solid company at a bottom instead of buying more.

It also doesn't help that we tend to feel the pain of a loss more strongly than we do the pleasure of a gain. It's this unwillingness to accept the pain early that might cause us to "ride losers too long" in the vain hope that they'll turn around and won't make us face the consequences of our decisions.

Pitfall: Sunk Costs

Another factor driving loss aversion is the sunk cost fallacy. This theory states that we are unable to ignore the "sunk costs" of a decision, even when those costs are unlikely to be recovered.

One example of this would be if we purchased expensive theater tickets only to learn prior to attending the performance that the play was terrible. Since we paid for the tickets, we would be far more likely to attend the play than we would if those same tickets had been given to us by a friend. Rational behavior would suggest that regardless of whether or not we purchased the tickets, if we heard the play was terrible, we would choose to go or not go based on our interest. Instead, our inability to ignore the sunk costs of poor investments causes us to fail to evaluate a situation such as this on its own merits.

Sunk costs may also prompt us to hold on to a stock even as the underlying business falters, rather than cutting our losses. Had the dropping stock been a gift, perhaps we wouldn't hang on quite so long.

Quiz 507
There is only one correct answer to each question.

1 What do experts in the field of behavioral finance study?
a. Factor investing
b. The psychology and the behaviors of investors, particularly the mistakes that they make.
c. Modern Portfolio Theory
2 Which statement below is true?
a. Studies show that overconfident investors trade more rapidly
b. Studies show that overconfident investors trade more rapidly
c. Studies show that overconfident investors trade just as rapidly as less-confident investors
3 What is a mental shortcut that causes us to give too much weight to recent evidence--such as short-term performance numbers--and too little weight to the evidence from the more distant past?
a. Representativeness
b. Self-handicapping
c. Loss aversion
4 What is loss aversion?
a. When we try to explain any possible future poor performance with a reason that may or may not be true
b. An obsessive focus on one investment that's losing money, even if the rest of their portfolio is in the black
c. Holding on to stocks that are doing well
5 Which statement is false?
a. The sunk cost theory states that we are unable to ignore the "sunk costs" of a decision, even when those costs are unlikely to be recovered.
b. Sunk costs may prompt us to hold on to a stock even as the underlying business falters, rather than cutting our losses
c. Sunk costs lead to rapid trading
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