Loss Aversion, Anchoring and Hope

“Almost” is a word full of frustration.  It just sticks it to you. No reasonably sensible person engages in any activity to almost finish.  Whether it is a marathon, a tree house, or trying to think of the perfect lyrics for the last line of your song, you have to finish the deal.  

As investors, we don’t enter the markets to purposefully earn below average returns. Nevertheless, many fail to achieve the desired returns they first had in mind.  Created in 1957, the standard benchmark for investor returns remains the S&P 500 Index. This index has earned over 10% per annum over the past 30 years.

In 2001, the research firm Dalbar, released startling market conclusions. Dalbar effectively argues in the Quantitative Analysis of Investor Behaviour (QAIB), that erratic investor actions are deadlier than any market crash.  Here are some of their findings from January 1984 through December 2000:

  • The average fixed-income investor realized an annualized return of 6.08%, compared to11.83% for the long-term Government Bond Index;
  • The average equity-fund investor realized an annualized return of 5.32%, compared to16.29% for the S&P 500 Index;
  • The average money-market fund investor realized an annualized return of 2.29%,compared to 5.82% for Treasury Bills and 3.23% for inflation.  (Money-market fund investors lost money after inflation.)

In the 16 years prior to December 2000, the S&P 500 Index yielded 16.29% per year, while the average investor yielded only 5.32% for the same period.  How could this be?  While there are a number of contributing factors for the significantly reduced individual investment returns, many of the most common behavioral causes point to loss aversion, anchoring and mental accounting as most damaging. 


Loss Aversion

As a part of prospect theory, loss aversion refers to the unbalanced attention given to avoiding losses, rather than acquiring gains.  The basic premise is that while investors buy and sell with the hope of yielding desirable returns, their actions are antithetical to this purpose.  The problem is this…the correct market approach is counter-intuitive to basic human nature.

This is ironic on many levels.  The market is fundamentally made up of humans engaging in billions of daily transactions. Whether these actions are direct or by proxy via technology, at the end of the day a human being stands last in line.  It would then follow, that the markets would be an amplified version of what the average individual of like intelligence would do in similar circumstances.  It tends to be just the opposite.

 
I Hope Not

Hope and the markets are a terrible mix.  Many investors make decisions with an expectation or comfort level with regards to acceptable levels of risk.  Only to find out later that risk on paper feels differently in real life.  Stop losses work great in a demo account, but are difficult to consistently adhere to in real world scenarios.

Understanding theoretical risk in your portfolio, and how to act when markets react unfavorably to your positions are two very different things.  Most investors select securities within their portfolio based on individual factors such as investible assets, knowledge of markets, and purpose of investment.

Unfortunately, too many choose to hold low performing securities, while selling their high better performing holdings; this is the height of loss aversion.  They hope the position will eventually change directions.  It rarely does.


Anchoring

It is good to be anchored, the question is, what are you anchored to?  If the picture is partially obscured, then the anchoring decision can bind us to something we can’t get rid of quick enough.

How do you select what the true market price of a security is when making investment decisions?  For some investors, they simply assume the price where the security currently trades is the correct market value.  Or, they view the most recent trading history to gain indication of price parameters.  When investors make decisions based upon the current or recent price activity of a particular security, rather than its entire trading genealogy, this is anchoring.

Investment decisions based on anchoring often fail to recognize past patterns and past performance indicators of the security being evaluated.  This behavioral failure can surface in our portfolios in the form of an unwillingness to part with losers.  As a consequence, we tie up capital, and squander better opportunities with higher probabilities of success.


Mental Accounting

Investors tend to view their stocks, bonds and ancillary investment decisions as separate compartments.  This is classic mental accounting.  Mental accounting can also be applied to each individual’s personal lives, acting as a driving force in daily behavior.

Mental accounting affects investors most significantly in an investment period directly following a bull market.  For example, the late 1990’s was a time where many investors experienced tremendous portfolio gains.  Mental accounting suggests that an investor would associate a specific level of return with a specific security based upon its prior performance.
This false association works until doesn’t.

This particular security today may only be earning modest or below average returns.  Yet, based on the concept of mental accounting, the investor would still hold this position, hoping one day it would return to its former glory.  Such behavior can cause missed opportunities by holding onto positions no longer relevant in today’s market.  The investment lesson here is we must recognize when the party is over, and govern ourselves accordingly.

 

For more information on BEHAVIORAL FINANCE, read these related articles:

Investors Beware the Herd

Over Confidence & Attribution Bias

The Enemy of Performance - You!