Systematic Relative Strength

We all want to feel good about ourselves. As a result, humans have a strong bias toward structuring their emotional environment to preserve their self-esteem. We attempt to maximize the perception of good decisions and to minimize the impact of poor decisions. Usually this results in the view that we have never made any poor decisions! Bad outcomes are explained away by interference from external factors, while good outcomes are always the result of clever and thoughtful decision-making.

In the financial market, psychological comfort is over-rated. The path to superior investment performance is generally through psychological discomfort. To get a sense for how much our psychological pain minimization impacts our investment decisions, consider some of Terrance Odean’s research, discussed in this article from Advisor One.

Terrance Odean, Rudd Family Foundation professor of finance at the Haas School of Business at the University of California, Berkeley, has been researching the impact of regret on the way people invest, in particular how regret—and the ways in which people try to manage it—conditions their behavior vis-à-vis the stock market.

His research through the years has shown, he says, that investors “seek to minimize the emotional experience of investing as much as they can,” and this tendency determines the ways in which they buy, hold and sell stock.

Case in point: In a recent study, the findings of which are yet to be released, Odean observed U.S. investors who went out into the market and bought a stock that they had owned in the past, but sold at a certain point in time. The results of the empirical study showed that investors bought a stock they’d owned before only if they made money on it the first time they owned it and only if the stock’s price had gone down since they bought it.

“This is all about regret: You would not want to buy back a stock that you’ve had a bad experience with, and if you sold for a gain but the stock price ended up rising when you sold, you wouldn’t want to own that stock again either, because you’re going to regret selling it,” Odean, (left), says. “But if you can sell for a gain and you can buy it for a better price, that’s when you will buy that stock again.”

It may sound simple, but regret is a huge parameter that most people are not even aware of, and managing regret plays a major part in the emotional side of financial decision-making.

Regret is also a key factor in what Odean calls the “disposition effect.” His research through the years has shown that investors are more disposed toward selling stocks that have made money, while holding onto those that are poor performers. Even though the results of this can be counterintuitive and even detrimental to a stock portfolio, the overriding reason has to do with managing their emotions vis-à-vis the stocks they own, in particular the regret at owning stocks that are poor performers.

“When people hold onto stocks that are losers, they are trying to minimize their regret, because if a person sells at a loss, he or she runs the risk of regretting that they bought that stock in the first place,” Odean says. “If people hold onto their poorly performing stocks, though, they’re doing so because they’re telling themselves that the market will come back, and they’re coping with their regret by convincing themselves that those stocks that are performing badly will turn around.”

Minimizing regret is a polite way to put it. Basically, investors avoid making certain transactions like the plague because it makes them feel stupid. It has nothing to do with the investment merits of the position and everything to do with hiding (even from yourself) the truth about your investment decisions.

The disposition effect shows that investors hold losers and sell winners. The ultimate outcome is that you will end up with a diversified portfolio of losers, because you’ve sold all the winners. This is clearly not a viable portfolio strategy—you actually want to do the opposite!—but investors do it to avoid feeling dumb. Odean points out that investors will not generally buy back a stock at a higher price than where they sold it. That results in the investor watching helplessly as a strong stock runs to new all-time highs. Instead of participating in the price movement, the investor is instead trying not to feel dumb.

The investor is confronted with karma boomerang: in an attempt not to appear dumb, the investor makes decisions that actually are dumb. Being willing to admit mistakes and move on is a great help toward investment performance, but that may not be achieved by many investors short of intense psychological therapy. Another alternative is to use a systematic model for investment. Not every decision will be correct, of course, but the investor can save face by blaming poor decisions on the dumb model. Most investors can improve their performance by passing over the controls, whether it is to a model, a mutual fund, or to an investment advisor. The main point is just to find a way to disengage your emotions from the investment process.

This entry was posted on Friday, November 11th, 2011 at 2:40 pm and is filed under Investor Behavior, Markets. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.