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TRADERS

Investors, don’t let human quirks and emotions get the better of you Add to ...

Like contestants on a game show, amateur investors often get it wrong. They can blame normal human impulses.

Say a stock goes up. The inevitable urge is to sell it and reap the gain, even if there’s a chance it could keep rising. If it does drop, the tendency is to hold onto it, in the hope that it might bounce back.

Yet this may be precisely what you shouldn’t do, says Terrance Odean, a professor known for his study of behavioural finance at the University of California, Berkeley’s Haas School of Business.

For one thing, selling a winning investment while holding onto a loser can result in capital-gains taxes. “If you are trading in a taxable account, that’s a good way to run up your tax bill. You’ll have a lower tax bill if you sell your losers and hold on to your winners,” Dr. Odean said.

The point is, that kind of bottom-line, rational decision-making isn’t likely to happen. Instead, we experience a more emotional response. It’s as if a studio audience is shouting bad advice inside the head of the active amateur.

Psychologists Daniel Kahneman and Amos Tversky showed this in their influential work on probability and risk. People will often judge a situation and make decisions based on heuristics, or basic rules of thumb. They also feel a strong aversion to loss.

Losses are felt more strongly, psychologically, than the equivalent gains. And so, when making a decision with the hope of a gain, people tend to be risk-averse. But when faced with certain loss, they become risk-seeking.

In prehistoric days, that kind of risk-seeking probably made sense – when staring down a fanged beast, for example. Yet, in the wilds of modern investing, it may not, as with the capital gains situation.

So, our emotions and intuition can be at odds with financial benefit.

“We enjoy when things go well in our lives. But when things go poorly, it’s much more salient and much more painful,” said Brad Barber, professor of finance at the graduate school of management at the University of California, Davis. “That’s where loss aversion gets its name. It can cause us to do strange things when we’re facing losses. It makes us more willing to take gambles.”

Yet it gets more complicated than that. Other psychological factors are likely also at play in a “a latticework of mental models,” to crib a phrase from Berkshire Hathaway vice-chairman Charlie Munger that’s routinely found on financial behaviour blogs.

Because emotions and sound investing typically don’t mix, Dr. Odean stresses that these observations need only apply to money that is okay to lose – “play” money that is not part of one’s retirement savings and financial needs.

“I want to be clear. My advice is generally that people should buy and hold low-cost mutual funds for retirement,” Dr. Odean said. Applying theories to one’s own buying and selling decisions should be done only with disposable cash.

Why? Here is another example of how erratic financial behaviour can be.

In an experimental study that Dr. Odean helped conduct, participants in a lab were seated behind computers, trading an imaginary security. The participants were paid based on how much money they made or lost trading, he said. In this type of environment, a bubble market typically arises as overconfidence kicks in.

But when participants were shown a video of an action-movie chase scene before the experiment, the resulting price bubble was even bigger.

So while famous bubbles driven by the 17th century Dutch tulip mania and late 1990s dot-com boom were driven by possibly rational expectations of ever-rising prices, excitement was also likely a driving force, pure and simple.

The natural reaction is to think that all we need is to exert some self-control. But even that’s not so easy.

Dan Ariely, an author and professor of psychology and behavioural economics at Duke University, says that people often make a Ulysses pact with themselves. (Ulysses asked his men to tie him to the ship’s mast to hold him back from the temptations of the Sirens.)

But as Dr. Ariely argues, technology itself can be an enticing Siren, offering up quick access to a plethora of temptations, from an array of financial vehicles to new ways to buy and sell them from home.

And finally, it can be difficult to evaluate risks in the first place. What some people selling a stock might see as a gain, others may see as a loss. Maybe they were expecting more. Maybe they had been deciding between two stocks and put their money in the one that earned less. It’s a question of how an outcome is perceived, how it is framed in the mind.

As Dr. Barber at UC Davis noted, “You can frame something as a gain or a loss depending upon how you essentially word a question.” And this also affects behaviour. It goes back to the theory of people acting less risky when receiving a potential gain, and more risky when facing certain loss.

Even if the outcome is the same – whether it’s perceived as a loss or as a gain, the outcome is still the same – people will be risk-seeking if the end result is seen as a loss, or so the theory goes.

“It means,” Dr. Odean said, “paying some attention to not act on your impulses but to start paying some attention to the biases that investors have, and how those biases tend to cost them money.”

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Follow on Twitter: @Guy_Dixon

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