You need to run risks to make a profit. So get ready to tackle your inner Scrooge
Imagine I offer you a bet on the toss of a coin: heads you win £120; tails you lose £100. How do you feel? Chances are, not very comfortable. The statistician in you likes the odds, but your stomach is churning at the prospect of being £100 down in a few seconds.
You’re not alone. In hundreds of experiments, looking at people with different cultures, professions and IQs, psychologists have found that people typically need about twice the potential gain to lure them into taking a bet where they will end up poorer if they lose.
Most of us, it turns out, are Scrooges by disposition, burdened with a hard-wired aversion to losing money. As investors, the first consequence of our natural miserliness — psychologists call it “loss aversion” — is a tendency to sell stocks and funds that have gained in price before we should.
By selling “winners”, this way we lock in the profit and realise the emotional benefit of the gain. However, by doing so we are also missing out on further profits from positions that may have a lot longer to run.
An effective antidote to this impulsive profit-taking is documenting your investment process, says Ben Kelly, the behavioural finance specialist at BlackRock, the funds group.
Keeping a diary of your financial moves will help to “outline the rationale for investing in a particular investment and what the expectations are of that investment”, he says.
Your tendency to sell out of a rising market isn’t the only unconscious bias you need to guard against. This same psychological loss aversion turns caution to foolhardiness when it comes to holding on to losing investments.
Imagine you receive a gift of £1,000 and this choice: either you give back £500 straight away, or you toss a coin. If it comes down heads, you can keep the £1,000. If it comes down tails, you lose the entire £1,000.
By selling “winning” shares we realise the emotional benefit of the gain but may be missing out on further profits
Now you’re far more likely to take the gamble. Framed as a chance to recover the loss of £500, the odds are appealing. The fear of losing money that pushed you away from the lower-odds bet before, will now push you into one where the chances are worse; when psychologists tweak the numbers they find that the guaranteed loss needs to be about £300 for subjects to avoid the coin-toss.
It is likely that you’ve experienced the temptation of holding on to losers to claw back the loss — it’s the same urge that has you double your bet to win back the cash you lost on the previous round of blackjack.
A clear record of your investment case helps here too; if the case for holding a stock has disappeared you should sell, regardless of where its price is.
“A crucial part of this is to state the risks: what might make the investment fail and what should you do if it does?” advises Dr Kelly.
A second route, popular among professional investors, is to employ “stop losses” — defining, when you buy, a clear price floor that will trigger a sale, regardless of what you think or feel at the time.
Loss aversion is part of your psychological make-up. Controlling it will be uncomfortable: you are likely to endure a few white-knuckle moments holding funds that you want to sell, as well as regrets when selling out of the failures. Remember, however, that your instincts here are playing against your interests as an investor.
“Our emotional wellbeing frequently trumps other motivations,” notes Dr Kelly. Resisting your impulses won’t be comfortable, but it will be profitable.
It’s all in the mind
If investment managers tell you that they have control of their loss aversion, don’t believe them.
A 2006 study by a US academic, crunched data on US mutual funds over a quarter of a century. On average, managers sold 3 per cent more winners (stocks that had recently gained in value) than losers (those that had recently fallen). Last year Schroders employed Shane Sutton, at the time the technical director of British Cycling, to train their managers out of this weakness.
Please follow and like us: