With the Colombo All Share Price Index off nearly 8% for the year (an index that excludes dividends, which are a crucial component of returns to investors) many disgruntled investors are finding it hard to let go off their losing stocks. Regulatory riskwill remain the most unrewarded risk in 2012. That does not absolve the responsibility of investors to be alive to their own behavioural and psychological shortcomings to investing.
Sideways markets have a tendency to allow investors let down their guard and be susceptible to bad selection. Lack of self-control tops the list; the inability to sell losing positions becomes an associated second. Impulse has served me well.
It does for most people in many situations of their life. Great guidance by some highly skilled monks have helped me (after years of training and hours of meditation) start to develop an automatic activation of what I call “second level thinking”. It’s the level of thinking that helps isolate good investments from bad. Above all, it has helped ingrain delayed gratification.
In a famous behavioural study, kids are given one chocolate (also marshmallows in the most famous case), and told that they can eat it immediately. But if they can wait until an adult comes back, they will get a second chocolate. The chocolate test is designed to find out whether kids prefer immediate gratification, or have the self-control to maximize their rewards. The ability to delay gratification at an early age predicts all manner of later success, including greater popularity, lower Body Mass Index (weight), and higher grades.
Psychologists have created a similar test for adults that uses money, not chocolates. You're asked to decide whether you'd like Rs. 1000 today, or Rs. 1100 tomorrow. Rs.1700 today, or Rs.2500 next week. Rs. 5000 today, or Rs.50,000 in one year. And so on. The more of a "discount" you're willing to accept in order to get the cash today, the more you prefer immediate gratification. Think of the discount rate as how much “return” you are willing to give up, to take something today.
Research shows that the higher your discount rate, the more likely you are to smoke, gamble, drive drunk, and have a miserable family life -- all examples of putting present pleasure ahead of later consequences. People with higher discount rates also procrastinate more, are less likely to save for retirement, and even less likely to wear a watch -- it's as if they are so focused on the present, time itself doesn't matter. This is why prudence always triumphs gratification especially during sideways markets. Make sure your next sale is based on fundamentals; not twitchy thumbs and the urge to do something.
Even the greatest mastery of self control however makes selling duds or losing stocks hard. Research published in 1998 by behavioural-finance professor Terrance Odean of the University of California, Berkeley, showed that individual investors are 50% more likely to sell a winning stock than a losing one —even though, on average, the stocks these investors sell go on to outperform while those they hold onto under-perform.
Why the reluctance to bail? Selling an underwater asset, says Prof. Odean, "isn't primarily about economic loss, it's about emotional loss." Once you sell below your purchase price, he believes, you can no longer tell yourself, "I still made a good choice, and it'll come back." Don’t for a second, think that your broker may be of any help either. Data from the US suggests portfolio managers and traders who cling to their losers under-perform those that don’t by a significant 4% per annum.
Unpublished research presented in Neuroeconomics sheds new light on this old problem. Neuroeconomics is an emerging field that combines the techniques of neuroscience with theories from psychology and economics to study financial behaviour.
In one study, led by Gregory Berns of Emory University, people lay inside a brain scanner while deciding to hold or sell an investment; the price of the asset changed randomly up or down. The researchers focused on the ventral striatum, a region of the brain that has been shown to respond to rewards, particularly when they are unexpected.
When an asset was underwater and its price rose, activity in the ventral striatum of the typical person in the experiment was "blunted," or insignificant, rather than robust. Many of the participants had hoped for a rise. Perhaps because these people got what they expected, an up-tick in price probably wasn't surprising, and therefore didn't excite this part of the brain's reward centre.
That suggests that many investors who are losing money may automatically assume—rightly or wrongly—that their position is bound to recover.
A study led by Camelia Kuhnen of Northwestern University provides a second flaw when it comes to dealing with losses. It found that people are much worse at estimating whether a bad investment will produce mild or severe losses than they are at predicting whether a winning investment will generate small or large gains. This is where mathematics helps and second level thinking is invaluable.
There are several steps that can help you dump your losers. First, ask not whether you should sell the investments, but rather if they are worth buying at today's price. If the answer is no, consider selling. Taking a loss is easier when you think of it as a swap—in which you replace a loser with a new investment in a similar (but not identical) asset—rather than a sale. That makes taking action easier, since you aren't forced to admit that your original judgment was a complete failure. Use the sideways market as an opportunity to get away from it all, stop reading all the broker “noise” and start developing your second level thinking.
(Kajanga is an Investment Specialist, based in Sydney Australia. You can write to him at firstname.lastname@example.org).