We've all been there. Well I have. And I’m sure many of you have too. Panic buying and selling stocks - in the heat of the moment when emotion causes us to make poor decisions. Buying on spikes, holding onto bad stocks forever, selling at the bottom, not taking profits, buying and selling too frequently - these are all common mistakes for investors - and 24/7 access to online portfolios, bullet boards full of dubious characters, and inexperience or poor research can lead to emotions getting the better of us.
I've done a bit of research into the reasons our emotions get in the way of making sound decisions. Why? Because I think I've probably learnt most of the lessons the hard way and at the start of 2013 I decided to do more research, and stick to an investing plan. It’s hard but it’s proving more successful. In hindsight I've still made some dubious decisions this year, but at least I am making more informed dubious decisions! And it's easier to hold myself to account when things go well or badly. Thinking about what my plan really is has helped me learn more about what works for me, in terms of timescales, risk, & return expectations etc.
To illustrate the consequences of not doing this, I confess that in 2011 I bought Angel Mining stock for no other reason than it was touted as a potential multi-bagger. I did very little research other than reading past RNS’s and a quick glance through the web site. There was no evidence that they would achieve their production projections, and looking back now wearing those lovely hindsight glasses, the company was riddled with debt, the mine was in a godforsaken corner of Greenland, they hadn't met any of their previous targets, were running on a shoe string, had severe staff retention issues, and failed to keep the market properly informed. Wow. I would have been better going to the casino. In fact it would have been far more enjoyable and I reckon without doubt the odds would have been better!
So why do we make these poor decisions? The following themes seem to be key to our psychology whilst trading:
In a 2006 study*, a researcher called James Montier found that 74% of 300 fund managers surveyed believed they had produced above average returns. I’m not a great mathematician, but even I know that only 50% of anything can be above average. The point is that many investors are over confident in their own abilities and judgement. We’re sure we’ll beat the market and that we've chosen good investments. And the big firms don't help with our expectations - take a look at the ridiculous advert at the end of this post! We pay more attention to the things we know about a stock that reinforce our positive belief in it, but pay less (or no) attention to the things we either don’t know, don’t understand, or that don’t meet with our thoughts on a stock.
As human beings we want to fit in. We mirror the actions or thoughts of others in order to do so. We look to find positions that validate our beliefs. As investors, we take notice of people who support our views, and discount as “paid derampers” people who challenge our beliefs. Even though we all know that the comments of many posters on bulletin boards are dubious, we still love it when their sentiment matches our position. And yet that is just bonkers. We don’t even know these people are real! Never met them, no idea of their values, education, knowledge, position, motivation, experience or truthfulness. For example, how many of you would admit in private that the poster “Dogpog” influenced, even a little, an investment in Range Resources? Go on, be honest. It’s madness. And where is Mr Dogsbollox now? Let’s just say I’m pretty sure he got out before the drop!
Evidence would suggest real stock market returns are over the long term. And by that they are not talking 3 months. Timescales of 10 years or more are not uncommon, and yet nowadays it seems that a few months, even weeks is seen as ages. Looking every day at a portfolio is madness! We should probably check in once every 2 weeks and not in-between. But to me that would be as difficult as giving up smoking or never having a glass of wine. I just can’t get by without looking at my portfolio every day, usually several times. But why? I generally buy stocks I hope to see a good return from over a year or two, so why do I torture myself checking on performance every day? Because I can, and this is why sometimes my iPhone isn't helpful as patience is easily eroded.
When portfolios sink underwater fear can quickly take over. In my experience losing “paper” money is not much easier than real money, and when fear kicks in it is easy to make rash decisions. Liquidating stock holdings, just as a stock hits an all time low, can feel like a relief, but it can be the worst time to sell up. If fundamentals change that may be a good reason to sell, but when “in the grip” of fear and financial loss it can be very hard to stand back and assess the situation rationally.
Greed causes us to hold onto winning stocks past the point of maximum return / time. We hopefully set exit prices when we buy into stocks, but how many of us move them, or think “what if I just raise it a bit higher” once those targets are met? The greed for bigger returns is a hard one to resist, especially when it is underpinned by a “can’t lose” mentality. If paper profit is already made, it’s easy to think that I can’t lose, as further increases will increase the paper losses, and a drop will mean I’m still ok, won’t it? But that’s only the case when you’re up. If the price then falls further, there is no way most of us will sell as we are left thinking that we didn't sell at the higher price and there is therefore no point selling at the lower price! We all know what it feels like when the price then continues to fall below our original buy in price
Assuming that a bear run, or bull run in a stock is going to reverse, “because statistically that's what is likely to happen” is known as gamblers fallacy. Basically this suggests that we tend to believe that once a stock has risen, it will fall, and once a stock has fallen, it will rise. This results in us selling stocks early before they then continue to rise much further, or not selling stocks as they fall because we believe they will surely rise again. Leaving aside real changes in a company’s performance or fundamentals, stocks are not statistically likely to rise or fall, just because they have fallen or risen before. There are many examples of investors selling out of companies like ASOS when they saw 50% growth, only to see the stock continuing to increase by 5000% over the following 2 years.
“If a stock used to be 50p, and it is now 10p, it must be cheap right?” Wrong. Anchoring is a psychological issue when a person judges the relative value of something based on something similar which gives a false sense of value. Those of us who are older than 30 will remember that £1 used to = US$2. But that doesn't mean that today’s £1=$1.5 is expensive. Because we are anchoring it on a false comparison.
In summary, lessons about emotions and investing are easy to learn, often the hard way, but very hard to implement. It’s easy to make the same mistakes again, and as most of us are connected to our portfolios constantly, via mobile or tablet, learning to control our emotions and make sound decisions is critically important.
*Montier, James, Behaving Badly (February 2, 2006). Available at SSRN: http://ssrn.com/abstract=890563 or http://dx.doi.org/10.2139/ssrn.890563
One of my favorite adverts - no experience, no capital and he's become a trader! Great. Next week he'll be non the wiser and broke! Let's hope Frank still feels great.