Emotions and investing don’t mix

Tuesday, January 29th, 2008 @ 10:13 pm | Finance, Personal

Traditionally and even in some macroeconomics courses, it is said that individuals act rationally and consider all known information in the decision-making process. Traders today know this is not true. In a world where financial institutions and hedge funds use 200-300:1 leverage and markets swing wildly, there is plenty of emotion and irrational behavior to go around. Winning traders and investors make money by consistently exploiting irrational behavior, whether is it shorting a stock that just got ahead of itself, or by buying dips that happen when people panic sell.

Human emotion is a major factor in the stock market, as you have probably felt all of these:

Hope: I hope it goes back to where I bought in, I just want to break even

Fear: It has gone down everyday for the last week, I don’t want to lose everything

Greed: It just keeps going up, I should double up. How can I lose?

Despair: I just keep losing money, maybe I should quit.

These senses may help people out in the real world, but in the financial markets it is good to keep your mind open and keep your emotions out of trading. These distortions in the market are called cognitive biases. Some of the major biases are:

Loss aversion: Tendency to avoid losses at the cost of gains. People view losing $1000 as more painful than not gaining $1000, even though from an investing perspective they are the same.

Sunk Costs effect: Tendency to value committed funds more than future funds. Investors have a natural tendency to not want to declare a loss and they make the decision based on what funds they have invested not whether it is a smart decision. For instance, lets say you invested $100K in Nortel at the height of the boom. As the stock started to decline you would start thinking that maybe you should have sold, but now isn’t a good time to sell. Why not? Well because you have lost money and if you sold now you would have ‘wasted’ that lost money. The decision that should be made is: If I only had the amount I had now and I didn’t lose anything before, would I invest in Nortel now?

Disposition effect: Lock in gains and ride losses… This one is almost a combination of a few of the earlier ones. People tend not want to make losses permanent, and with the long term trend of the economy expanding they feel that the stock is just about bottomed, when it may or may not have. There is a fear of selling at the bottom and ‘wasting’ money. Also the tendency to make gains permanent, when you have just broke even or a little above it after taking on significant risk to achieve sets the trader up for long term losses.

Outcome bias: Judging decisions by the outcome and not the quality of the decision at time zero. This one is important, and one I personally had to learn the hard way when I first started. I got lucky on one of my first trades, and caught a LOT of wind at my back. Well human nature tells me to repeat said risky play, and of course, I lost. Doing something stupid and getting lucky is much WORSE than doing something smart and getting hurt a bit. If you keep making smart decisions you will make money, if you don’t you will be like Tim Sykes…no I don’t mean a millionaire.

Recency Bias: Tendency to weigh recent data or experience more than earlier data. Ever learn some new techniqu and think it was the greatest thing since sliced bread? Yep, everyone has and what inevitably happens is you tend to use that technique or piece or piece of data for things it was never intended or suited to do.

Anchoring: The tendency to focus on a particular piece of information. Ok here is another personal lesson. I had focused on AMD and them getting a distribution deal with Dell, and thinking this was going to create a Duopoly, what I failed to see was everything else going on with margins and Intel. Another example of this is using recent highs to set sell targets, people fixate on those highs and initially it may not have felt like a good price to sell at, but the next time around everybody is willing to let go of their shares for that amount.

Bandwagon: Believe in something because other people do. This is self explanatory, see tech boom.

Belief in the law of small numbers: Tendency to make claims or unjustified conlucions from too little information. I am going to use almost any fad that has died, something that may be hot or popular with a small section of consumers may not scale when the product goes global. Also a good example would be when some small orders at really high prices go through, while a few people may have paid that amount, low volume price movements really don’t mean too much to the valuation of the stock.