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407-Psychology and Investing
  Course 407:
  Psychology and Investing
  
  Successful investing is hard, but it doesn't require genius. In fact, Warren
  Buffett once quipped, "Success in investing doesn't correlate with I.Q. once
  you're above the level of 25. Once you have ordinary intelligence, what you
  need is the temperament to control the urges that get other people into
  trouble in investing." As much as anything else, successful investing requires
  something perhaps even more rare: the ability to identify and overcome one's
  own psychological weaknesses.
  
  Over the past 20 years, psychology has permeated our culture in many ways.
  More recently its influences have taken hold in the field of behavioral
  finance, spawning an array of academic papers and learned tomes that attempt
  to explain why people make financial decisions that are contrary to their own
  interests.
  
  Experts in the field of behavioral finance have a lot to offer in terms of
  understanding psychology and the behaviors of investors, particularly the
  mistakes that they make. Much of the field attempts to extrapolate larger,
  macro trends of influence, such as how human behavior might move the market.
  
  In this lesson we'd prefer to focus on how the insights from the field of
  behavioral finance can benefit individual investors. Primarily, we're
  interested in how we can learn to spot and correct investing mistakes in order
  to yield greater profits.
  
  Some insights behavioral finance has to offer read like common sense, but with
  more syllables.
  
  
  Overconfidence
  
  Overconfidence refers to our boundless ability as human beings to think that
  we're smarter or more capable than we really are. It's what leads 82% of
  people to say that they are in the top 30% of safe drivers, for example. 
  Moreover, when people say that they're 90% sure of something, studies show
  that they're right only about 70% of the time. Such optimism isn't always bad.
  Certainly we'd have a difficult time dealing with life's many setbacks if we
  were die-hard pessimists.
  
  However, overconfidence hurts us as investors when we believe that we're
  better able to spot the next Microsoft MSFT than another investor is. Odds
  are, we're not. (Nothing personal.)
  
  Studies show that overconfident investors trade more rapidly because they
  think they know more than the person on the other side of the trade. Trading
  rapidly costs plenty, and rarely rewards the effort. We'll repeat yet again
  that trading costs in the form of commissions, taxes, and losses on the
  bid-ask spread have been shown to be a serious damper on annualized returns.
  These frictional costs will always drag returns down.
  
  One of the things that drive rapid trading, in addition to overconfidence in
  our abilities, is the illusion of control. Greater participation in our
  investments can make us feel more in control of our finances, but there is a
  degree to which too much involvement can be detrimental, as studies of rapid
  trading have demonstrated.
  
  
  Selective Memory
  
  Another danger that overconfident behavior might lead to is selective memory.
  Few of us want to remember a painful event or experience in the past,
  particularly one that was of our own doing. In terms of investments we
  certainly don't want to remember those stock calls that we missed (had I only
  bought eBay EBAY in 1998) much less those that proved to be mistakes that
  ended in losses.
  
  The more confident we are, the more such memories threaten our self-image. How
  can we be such good investors if we made those mistakes in the past? Instead
  of remembering the past accurately, in fact, we will remember it selectively
  so that it suits our needs and preserves our self-image.
  
  Incorporating information in this way is a form of correcting for cognitive
  dissonance, a well-known theory in psychology. Cognitive dissonance posits
  that we are uncomfortable holding two seemingly disparate ideas, opinions,
  beliefs, attitudes, or in this case, behaviors, at once, and our psyche will
  somehow need to correct for this.
  
  Correcting for a poor investment choice of the past, particularly if we see
  ourselves as skilled traders now, warrants selectively adjusting our memory of
  that poor investment choice. "Perhaps it really wasn't such a bad decision
  selling that stock?" Or, "Perhaps we didn't lose as much money as we thought?"
  Over time our memory of the event will likely not be accurate but will be well
  integrated into a whole picture of how we need to see ourselves.
  
  Another type of selective memory is representativeness, which is a mental
  shortcut that causes us to give too much weight to recent evidence--such as
  short-term performance numbers--and too little weight to the evidence from the
  more distant past. As a result, we'll give too little weight to the real odds
  of an event happening.
  
  
  Self-Handicapping
  
  Researchers have also observed a behavior that could be considered the
  opposite of overconfidence. Self-handicapping bias occurs when we try to
  explain any possible future poor performance with a reason that may or may not
  be true.
  
  An example of self-handicapping is when we say we're not feeling good prior to
  a presentation, so if the presentation doesn't go well, we'll have an
  explanation. Or it's when we confess to our ankle being sore just before
  running on the field for a big game. If we don't quite play well, maybe it's
  because our ankle was hurting.
  
  As investors, we may also succumb to self-handicapping, perhaps by admitting
  that we didn't spend as much time researching a stock as we normally had done
  in the past, just in case the investment doesn't turn out quite as well as
  expected. Both overconfidence and self-handicapping behaviors are common among
  investors, but they aren't the only negative tendencies that can impact our
  overall investing success.
  
  
  Loss Aversion
  
  It's no secret, for example, that many investors will focus obsessively on one
  investment that's losing money, even if the rest of their portfolio is in the
  black. This behavior is called loss aversion.
  
  Investors have been shown to be more likely to sell winning stocks in an
  effort to "take some profits," while at the same time not wanting to accept
  defeat in the case of the losers. Philip Fisher wrote in his excellent book
  Common Stocks and Uncommon Profits that, "More money has probably been lost by
  investors holding a stock they really did not want until they could 'at least
  come out even' than from any other single reason."
  
  Regret also comes into play with loss aversion. It may lead us to be unable to
  distinguish between a bad decision and a bad outcome. We regret a bad outcome,
  such as a stretch of weak performance from a given stock, even if we chose the
  investment for all the right reasons. In this case, regret can lead us to make
  a bad sell decision, such as selling a solid company at a bottom instead of
  buying more.
  
  It also doesn't help that we tend to feel the pain of a loss more strongly
  than we do the pleasure of a gain. It's this unwillingness to accept the pain
  early that might cause us to "ride losers too long" in the vain hope that
  they'll turn around and won't make us face the consequences of our decisions.
  
  
  Sunk Costs
  
  Another factor driving loss aversion is the sunk cost fallacy. This theory
  states that we are unable to ignore the "sunk costs" of a decision, even when
  those costs are unlikely to be recovered.
  
  One example of this would be if we purchased expensive theater tickets only to
  learn prior to attending the performance that the play was terrible. Since we
  paid for the tickets, we would be far more likely to attend the play than we
  would if those same tickets had been given to us by a friend. Rational
  behavior would suggest that regardless of whether or not we purchased the
  tickets, if we heard the play was terrible, we would choose to go or not go
  based on our interest. Instead, our inability to ignore the sunk costs of poor
  investments causes us to fail to evaluate a situation such as this on its own
  merits. Sunk costs may also prompt us to hold on to a stock even as the
  underlying business falters, rather than cutting our losses. Had the dropping
  stock been a gift, perhaps we wouldn't hang on quite so long.
  
  
  Anchoring
  
  Ask New Yorkers to estimate the population of Chicago, and they'll anchor on
  the number they know--the population of the Big Apple--and adjust down, but
  not enough. Ask people in Milwaukee to guess the number of people in Chicago
  and they'll anchor on the number they know and go up, but not enough. When
  estimating the unknown, we cleave to what we know.
  
  Investors often fall prey to anchoring. They get anchored on their own
  estimates of a company's earnings, or on last year's earnings. For investors,
  anchoring behavior manifests itself in placing undue emphasis on recent
  performance since this may be what instigated the investment decision in the
  first place.
  
  When an investment is lagging, we may hold on to it because we cling to the
  price we paid for it, or its strong performance just before its decline, in an
  effort to "break even" or get back to what we paid for it. We may cling to
  subpar companies for years, rather than dumping them and getting on with our
  investment life. It's costly to hold on to losers, though, and we may miss out
  on putting those invested funds to better use.
  
  
  Confirmation Bias
  Another risk that stems from both overconfidence and anchoring involves how we
  look at information. Too often we extrapolate our own beliefs without
  realizing it and engage in confirmation bias, or treating information that
  supports what we already believe, or want to believe, more favorably.
  For instance, if we've had luck owning Honda HMC cars, we will likely be more
  inclined to believe information that supports our own good experience owning
  them, rather than information to the contrary. If we've purchased a mutual
  fund concentrated in health-care stocks, we may overemphasize positive
  information about the sector and discount whatever negative news we hear about
  how these stocks are expected to perform.
  Hindsight bias also plays off of overconfidence and anchoring behavior. This
  is the tendency to re-evaluate our past behavior surrounding an event or
  decision knowing the actual outcome. Our judgment of a previous decision
  becomes biased to accommodate the new information. For example, knowing the
  outcome of a stock's performance, we may adjust our reasoning for purchasing
  it in the first place. This type of "knowledge updating" can keep us from
  viewing past decisions as objectively as we should.
 
 Mental Accounting
  If you've ever heard friends say that they can't spend a certain pool of money
  because they're planning to use it for their vacation, you've witnessed mental
  accounting in action. Most of us separate our money into buckets--this money
  is for the kids' college education, this money is for our retirement, this
  money is for the house. Heaven forbid that we spend the house money on a
  vacation.
  Investors derive some benefits from this behavior. Earmarking money for
  retirement may prevent us from spending it frivolously. Mental accounting
  becomes a problem, though, when we categorize our funds without looking at the
  bigger picture. One example of this would be how we view a tax refund. While
  we might diligently place any extra money left over from our regular income
  into savings, we often view tax refunds as "found money" to be spent more
  frivolously. Since tax refunds are in fact our earned income, they should not
  be considered this way.
  For gambling aficionados this effect can be referred to as "house money."
  We're much more likely to take risks with house money than with our own. For
  example, if we go to the roulette table with $100 and win another $200, we're
  more likely to take a bigger risk with that $200 in winnings than we would if
  the money was our own to begin with. There's a perception that the money isn't
  really ours and wasn't earned, so it's okay to take more risk with it. This is
  risk we'd be unlikely to take if we'd spent time working for that $200
  ourselves.
  Similarly, if our taxes were correctly adjusted so that we received that
  refund in portions all year long as part of our regular paycheck, we might be
  less inclined to go out and impulsively purchase that Caribbean cruise or
  flat-screen television.
 
Framing Effect
  One other form of mental accounting is worth noting. The framing effect
  addresses how a reference point, oftentimes a meaningless benchmark, can
  affect our decision.
  Let's assume, for example, that we decide to buy that television after all.
  But just before paying $500 for it, we realize it's $100 cheaper at a store
  down the street. In this case, we are quite likely to make that trip down the
  street and buy the less expensive television. If, however, we're buying a new
  set of living room furniture and the price tag is $5,000, we are unlikely to
  go down the street to the store selling it for $4,900. Why? Aren't we still
  saving $100?
  Unfortunately, we tend to view the discount in relative, rather than absolute
  terms. When we were buying the television, we were saving 20% by going to the
  second shop, but when we were buying the living room furniture, we were saving
  only 2%. So it looks like $100 isn't always worth $100 depending on the
  situation.
  The best way to avoid the negative aspects of mental accounting is to
  concentrate on the total return of your investments, and to take care not to
  think of your "budget buckets" so discretely that you fail to see how some
  seemingly small decisions can make a big impact.
  In investing, just remember that money is money, no matter whether the funds
  in a brokerage account are derived from hard-earned savings, an inheritance,
  or realized capital gains.
 
Herding
  There are thousands and thousands of stocks out there. Investors cannot know
  them all. In fact, it's a major endeavor to really know even a few of them.
  But people are bombarded with stock ideas from brokers, television, magazines,
  Web sites, and other places. Inevitably, some decide that the latest idea
  they've heard is a better idea than a stock they own (preferably one that's
  up, at least), and they make a trade.
  Unfortunately, in many cases the stock has come to the public's attention
  because of its strong previous performance, not because of an improvement in
  the underlying business. Following a stock tip, under the assumption that
  others have more information, is a form of herding behavior.
  This is not to say that investors should necessarily hold whatever investments
  they currently own. Some stocks should be sold, whether because the underlying
  businesses have declined or their stock prices simply exceed their intrinsic
  value. But it is clear that many individual (and institutional) investors hurt
  themselves by making too many buy and sell decisions for too many fallacious
  reasons. We can all be much better investors when we learn to select stocks
  carefully and for the right reasons, and then actively block out the noise.
  Any temporary comfort derived from investing with the crowd or following a
  market guru can lead to fading performance or inappropriate investments for
  your particular goals.
 
 The Bottom Line
  In this brief overview of behavioral finance, we've touched on the major
  tendencies that influence everyday investors. Being aware of these influences
  can make it less likely that you will succumb to them.