Emotion is the Enemy
Hubris, fear, impatience, complacency--these are examples of emotional responses that can get us into financial trouble.
My magical potion
You're emotion in motion to me
The price of a stock that you bought last year has decreased 70% below your cost basis as the fundamentals of the company and industry have deteriorated. You 'know' that you're likely better off selling this position, but you continue to hold it hoping that the stock somehow rallies to your entry price so that you can break even. Emotion may be clouding your judgment.
Effective market participants are aware of the various human 'defects' that impede effective money management.
Emotion is the Enemy...
Market participants sometimes find themselves all 'twisted around' their trading positions, and wind up adding exposure because they become impatient and fearful that the market would rally without them. Words like 'impatient' and 'afraid' are expressions of human emotion that are unwelcome visitors to financial thought processes. A familiar mantra of Minyanville is that emotion is the enemy when making financial decisions. Emotion impedes clear thinking and often causes people to take more risk than they should when managing money.
Chart courtesy of StockCharts.com
Many are familiar with the spectacular rise and subsequent decline in the Nasdaq Composite (COMP) in the late 1990s and early 2000s. What caused the huge price run-up and subsequent decline expressed by the spike-like pattern in this chart? Although many factors likely contributed (Shiller, 2000), we can confidently assume that human emotions played a significant role.
Hubris, fear, impatience, complacency--these are examples of emotional responses that can get us into financial trouble. Emotions can cause us to be reward seekers rather than risk managers, thereby leading us to take on riskier positions than than we should. Emotions can also cause us to stick with losing positions too long. The developing field of behavioral finance has identified a number of psychological 'defects' that inhibit effective money management.
a) Taking More Risk When Losing (Prospect Theory)
Let's say you bought a stock that has since declined 20%. You're desperate to make it back to even and are considering buying more of the stock to lower your cost basis and speed the path to profitability when the stock price rises. If you've invested in financial markets before, then you might recognize this common situation. It reflects a behavioral tendency that works against us in financial decision-making. Once we've lost money, we are often willing to take on more risk to try to get back to even. The tendency to take more risk when losing is part of what is known as 'Prospect Theory.' In their seminal work, Kahneman and Tversky (1979) found that individuals tend to take more risk when they are losing money and less risk when they are ahead. If you think about it, this is the opposite what we probably should do in many cases. When operating at a loss, individuals should think twice before betting more in order to preserve capital for better opportunities down-the-road. Rather than 'throwing good money after bad', a more useful approach may be to remove emotion from the decision making process, cut your losses, and wait for a more favorable situation.
b) Using Initial Data as a Reference (Anchoring)
Suppose that you're interested in Procter & Gamble (PG) stock, but you've never studied the price. So you call up a PG quote and it indicates $63.80. Because this is the first price of PG that you've ever seen, chances are that $63.80 will stick with you. You may even base future financial decisions on this price. If at some point in the future you entertain buying PG, you might decide that you won't buy it unless the price goes lower than $63.80. The $63.80 price becomes an anchor--you are anchoring your future decisions to a particular price. An anchor is a reference point, and it often exerts considerable influence on subsequent decision making (e.g., Kristensen & Garling, 1997). While points of reference can be desirable, in financial matters they often cause folks to make arbitrary, irrational decisions. You might notice a relationship between anchoring and Prospect Theory above, since individuals tend to take on more risk as losses grow based on the position's price anchor.
c) Overconfidence Bias
Each of us tends to think we're better than average. In financial markets, participants commonly think they they can outperform market averages--often with poor results (Stone, 1994; Daniel et al., 1998). Think about it. There are 'macro' funds and institutions running billions of dollars out there with the resources (and motivation) to build the best information systems and analytical processes in the world. Yet, we often think we 'know' more than these folks. This would be humorous were it not for the financial consequences that often flow from this attitude. Does this mean that you should not participate in financial markets? Not necessarily. It means that you need to define your edge before putting capital at risk.
d) Framing/Selective Reasoning (a.k.a. Confirmation Bias)
Effective market participants often need to check themselves to ensure that they are not practicing tunnel vision--focusing only on data and arguments that support their investment or trading positions. This undesirable trait reflects a broader human 'defect' known as cognitive dissonance or confirmation bias. Cognitive dissonance refers to how humans deal with inconsistencies in their beliefs, and often results in 'selective' information processing that causes individuals (e.g., investors) to cling to their beliefs despite reasonable and factual evidence to the contrary. This process is sometimes referred to as 'framing'--as in framing all the facts in a way that is convenient to one's point of view. Framing can cause individuals to enter an ill-advised a financial position or stick with it longer than they should.
e) Running With the Crowd (Herd Behavior)
There's safety in numbers. This has been burned into our DNA from prehistoric times. When it comes to financial markets, is running with the herd a good thing? After all, there can be a collective wisdom in crowd behavior (Surowiecki, 2004) which helps underpin the efficient market hypothesis (Fama, 1970). However, it has been long observed that crowds often get it wrong (e.g., Mackay, 1852)--particularly at extremes. Look no further than recent U.S. stock market history for a great example. A huge run up in stock prices in the late 1990's was followed by a breathtaking decline over the next couple of years. Making sense of financial market environments requires sensitivity to market phenomena that reflect herd behavior. Market participants need to be aware of the consequences and risks of running with the crowd, since prices tend to reverse when a trend becomes crowded. Why so? Here's a rough model of one plausible herding mechanism:
i) People observe a few individuals getting rewarded for their behavior
ii) A crowd grows as more and more people seek to join the herd for similar reward
iii) Herd takes behavior to greater extremes in search of reward
iv) The crowd gains power as more people seek the benefits of large numbers
v) Once a herd loses ability to feed itself and its needs, the crowd dissolves, often quickly.
Indeed, understanding the mechanics of herd behavior may be one of the most important tools in a market participant's toolbox.
The list of 'defects' noted above is not exhaustive, but it offers some of the more common behavioral tendencies that often lead to financial decision-making breakdowns. Being aware that you possess them will help you compensate for them.
Fama, E.F. (1970). Efficient capital markets: A review of theory and empirical work. Journal of Finance, 25: 383-417.
Daniel, K., Hirshliefer, D. & Subrahmanyam, A. (1998). Investor psychology and security market under- and overperformance. Journal of Finance, 53: 1839-1885.
Kahneman, D. & Tversky, A. (1979). An analysis of decision under risk. Econometrica, 47: 263-292.
Kristensen, H. & Garling, T. (1997). The effects of anchor points and reference points on negotiation process and outcomes. Organization Behavior and Human Decision Processes, 71(1): 85-94.
Mackay, C. (1856). Memoirs of extraordinary popular delusions and the madness of crowds. London: Office of the National Illustrated Library.
Shiller, R.J. (2000). Irrational exuberance. Princeton, NJ: Princeton University Press.
Stone, D.N. (1994). Overconfidence in initial self-efficacy judgments: Effects on decision processes and performance. Organization Behavior and Human Decision Processes, 59(3): 452-474.
Surowiecki, J. (2004). The wisdom of crowds: Why the many are smarter than the few and how collective wisdom shapes business, economies, and nations. New York: Doubleday.
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