When someone asks me what it takes to be a good investor, I’m somewhat at a loss for words. It’s not because I can’t explain it, but because there are so many facets to the discussion I never know where to begin.
I could ask “If you’ve lost money in a stock that you haven’t sold, is it only on paper, or did you really lose it?” Or I could role play and pretend to flip a coin and record your responses. And on that note, and before anything else, even before you start looking at the stock market, I’d like to help you look at human tendencies, and how they relate to investing, because more than you might think, they play a role.
I hope to show you things you may not realize about yourself; things that once mastered, you’ll be able to apply in a surprisingly large number of situations, even outside of investing. Only after understanding your emotional responses to market movements and your natural inclinations should you move into the next phase: analyzing and investing in companies. That’s what I hope to do: show you the difference between subjective and objective decision making with investments, and how, statistically, you are more likely to earn a higher return if you can invest objectively.
There is a concept known as prospect theory, which was originally presented by Kahneman and Tversky in 1979. As it goes, people do not respond equivalently to gains and losses... that is, they do not enjoy gains in the same magnitude that they dislike losses. Losses, as the study showed, are typically felt in a greater magnitude.
Additionally, every loss is felt separately (as are gains), not cumulatively. That is to say, it hurts a lot more to lose $500 twice, than it does to lose $1,000 once. If you had two stocks, would you rather have both down $500, or one down $1,000?
Now for the test: I will give you the choice between two coin flips:
Coin Flip #1: Heads you make $1,000, Tails you make $0. (a gamble)
Coin Flip #2: Heads you make $500. Tails you also make $500. (a certainty)
Before reading on, pick the one above that you would most likely choose.
Now I’ll give you two different coin flip options, and you must choose one of them.
Coin Flip #1: Heads you lose $0. Tails you lose $1,000. (a gamble)
Coin Flip #2: Heads you lose $500. Tails you also lose $500. (a certainty)
In Kahneman and Tversky’s original test, it would have been rational for any individual to choose either the gamble or the certainty consistently in both cases. However, the majority chose the guaranteed gain (Flip #2) first, and the gamble at losing nothing (Flip #1 for the second). Because the pain of losing is by default greater than the joy of winning, people were more inclined to take the gamble to lose nothing, hence avoiding pain, yet more inclined to take guaranteed gain.
This theory can explain a certain type of behavior in investors, known as the disposition effect, which is the inclination of investors to hold on too long to stocks losing value, in hopes of recovering, and to sell stock rising in value too quickly, for fear of losing the gain.
This results in a negatively skewed distribution of stock returns, with small gains, and large losses. Because people inappropriately think of losses as only “real” if the investments are sold, there is a tendency to allow a higher degree of risk to avoid the pain of recognizing the loss. In the same vein, there is less tendency to “gamble” when an investment shows a gain, as it more preferable to take the guaranteed gain. This is typical risk-averse behavior, but notice how the typical reaction is different in polar scenarios (gain vs. loss).