Investor behavior seems stubbornly to resist all attempts to reform it. The primary reason is that investor behavior is rooted in emotions, not all of which are healthy. One problematic emotion that academics have identified is regret. The Psy-Fi blog recently carried a nice piece on regret, which I have excerpted here. (For the full post, you can go to this link.)
-”It makes perfectly rational sense in most walks of life to avoid situations that give rise to feelings of regret. Swapping lottery numbers and then seeing the sequence you’ve chosen for the last five years come up would be a horrible feeling although, rationally, the two sets of numbers are equally likely. Of course, rationally, you should never buy lottery tickets at all.
However, when it comes to stocks and shares regret is a terribly dangerous emotion because our attempts to avoid suffering from it lead us to do financially stupid things. Amongst the most irrational is to avoid selling shares at a loss. This happens frequently when people need to sell, for one reason or another. This may be to buy some other super future performer or simply to raise cash for another venture. The evidence strongly suggests that when people do sell their shares they overwhelmingly prefer to sell those that have made them a profit rather than those that are trading at a loss.
Rationally, the best basis for choosing which shares to buy should be to sell those you believe will perform less well in the future rather than those that are selling below some buying price anchoring value. But, no, people will sell winners and keep losers in order to avoid the feeling of regret that comes from making a duff investment. Such a trade also allows them the satisfaction of pride from having had a winner, an equally irrational response, especially as the damn things will usually carry on going up.
The Disposition Effect
Psychologists call this the disposition effect. It was beautifully illustrated in a study by Ferris, Haugen and Makhija in 1988 who showed that stocks which had had gains had higher transaction volume than those that had had losses: people were hanging onto their losers and trading away their winners. Further work by Terence Odean indicated that investors were 50% more likely to sell a winner than a loser and that the outperforming stocks that investors were selling went on to outperform over the rest of the year in which the trade was carried out.
The disposition effect is really a partial statement of something we’ve seen before – loss aversion, the unwillingness of investors and golfers to face up to a loss. However, regret takes us a step beyond this because it shows that simple loss aversion has longer term effects. Even better – or worse – the disposition effect doesn’t just say that we’ll avoid selling our losers but also that we’ll preferentially sell our winners in order to avoid selling losers. The effect appears to be fairly constant across all sorts of investors – professional and amateur, experienced and otherwise although there’s some limited evidence from Dhar and Zhu that experience reduces the impact of regret on trading decisions.
Future Choice
However, the disposition effect has ramifications far beyond simple loss aversion. No, as Barber, Odean and Strahilevitz have shown, the impact of this continues after a sale of stock has been made. Investors’ feelings of regret or pride impact their subsequent decisions about trading in the same stock. So they will buy back stocks they have previously sold for a profit, but not for a loss, in an attempt to repeat the pleasurable feelings they got from the previous trade.
That’s not all. Investors will also buy back a stock that’s trading at a lower price than they previously sold it for but not a higher price. This is also a pleasurable experience and although avoiding buying companies that have done well since a sale may well be irrational it at least avoids needing to face further feelings of regret on that particular score.
Finally investors vastly prefer to buy more shares in companies they already own if the share price has declined, but not if it’s gone up. This process of “averaging down” increases the potential for future pleasure and reduces possible future regret as the reference average buying price of the stock is reduced.
None of these strategies improves portfolio performance, of course. Quite the opposite according to the researchers.”-
Therein lies the problem. Data suggests a better way of dealing with portfolio issues, but emotions want to handle the problem another way. Unfortunately, the emotions make things worse rather than solving the problem. Our recognition of these behavioral issues is why we opted to operate all of our managed account products on a systematic basis. Building an adaptive model to incorporate our expertise and to expose the portfolio to a factor that outperforms over time is much easier from a distance when you don’t have to worry about the market swinging up and down. Now that the model is built, all we have to do is execute it. (Well, and maintain it and continue to try to improve it. It’s not as simple as it sounds.) Deciding to use a systematic approach is one thing about which we have no regrets.
Posted by Mike Moody 
