How Thinking Affects Investing: Part 2 of 4

This is the second in a series of four columns.  The purpose of the series is to discuss the practical lessons we can learn from behavioral economics, the branch of economics that studies how decision-making is influenced by what we feel and what we think.

In Part 1, I explained that most people are poor investors because they make decisions primarily to avoid emotional discomfort.  This is because their thinking patterns are unconsciously influenced by heuristics and cognitive biases.

“Heuristics” are mental shortcuts that underlie our decision-making processes.  We use heuristics many times a day to help us make good decisions quickly, often with minimal information.  However, when we apply heuristics to the stock market — which is much different from everyday life — they often lead us astray.

“Cognitive biases” are powerful patterns of thinking, mostly irrational, that tend to always lead us astray.

So far, we have discussed two such ideas:

1. False Analogies to the Physical World

Interpreting investment information, such as graphs, as if they were describing phenomena in the physical world.  This leads us to assume that stock prices act as if they are following the laws of gravity and inertia.

2. Representation Bias

Assuming that similar circumstances will lead to similar outcomes.  This leads us to assume that the past can predict the future.

Is this column, we will discuss several more related ideas:

3. Loss Aversion

4. Endowment Effect

5. Disposition Effect

6. Sunk-Cost Effect

7. Anchoring

Loss Aversion: Let’s say you are in a situation where you must choose one of the following: You can either avoid losing $1,000, or you can gain $1,000.  Logically, these two choices are equivalent, so it shouldn’t matter which one you pick.  Nevertheless, because of a cognitive bias we call “loss aversion,” most people tend to select the first choice.  Why?  Because, for most human beings, the satisfaction that comes from avoiding a loss is much stronger than the satisfaction that comes from acquiring a similar gain.

The fact is, every successful investor will have times when he or she is faced with the need to accept a loss and move on.  The decision should be made rationally, without emotion and without unnecessary delay.

This is why loss aversion causes us so much trouble.  Because we suffer disproportionately from losses, the fear of a loss has more power over our behavior than does the prospect of a gain.  As a result, we often find ourselves maneuvering to avoid the internal discomfort that comes with a loss even when what we are doing is, rationally, not in our best interest.  Moreover, because this all happens beyond our conscious awareness, we invariably fool ourselves into thinking we are making the best possible decisions when we are actually acting irrationally.

As an investor, you can expect loss aversion to manifest itself in three important ways, each of which is a cognitive bias in its own right:

• Endowment Effect

• Disposition Effect

• Sunk-Cost Effect

My goal is to help you become aware of these specific cognitive biases and to show you how to avoid them when you make investment decisions.  In the long run, such insight into your emotional nature will pay off handsomely.

Harley’s Rule of Investing #3: The most expensive tuition is what you end up paying the market to teach you how to take a loss.

Endowment Effect: The “endowment effect,” sometimes called “ownership bias,” dictates that when we own something, we place a higher value on it than if we would if didn’t own it.

It is the endowment effect that is, in large part, responsible for so many of the useless objects that clutter people’s homes.  Once we own something, it can be difficult to throw it out or give it away, even if we don’t really need it.  (How much easier it is to not acquire such objects in the first place!)  On the other hand, it is easy to go through someone else’s belongings and point out all the unnecessary junk.

The endowment effect is particularly strong when we buy and sell stocks.  Consider the following example.

Person A owns $1,000 worth of stock in the XYZ Company.  Person B has no stock, but he has $1,000 in cash.  Person A and Person B discuss the merits of XYZ and come to the conclusion, together, that, right now, holding stock in the company would be a bad investment.  There are better ways for each of them to use $1,000.

If you are Person B, you, will find it easy to not use your $1,000 to buy XYZ stock.  After all, you have just decided it is a poor investment.

If you are Person A, however, you will find it much more difficult to sell your $1,000 worth of stock.  Why?  Because you already own the stock.

Because of the endowment effect, the stocks you own seem more valuable than they would if you didn’t own them, which makes them all the more difficult to sell.

Harley’s Rule of Investing #4: The stock doesn’t care who owns it.

Disposition Effect: A second cognitive bias caused by loss aversion is the “disposition effect”: the tendency to wait too long to take losses or to move too quickly to realize gains.

Because most of us tend to be loss averse, we will often hold onto a stock that has decreased in value long past the time when it would have made sense to sell.  By hanging onto the stock and hoping it will go back up, we are able to avoid the regret that comes from acknowledging that the loss is permanent.

Conversely, when we are fortunate enough to have one of our stocks go up quickly, loss aversion will often induce us to sell the stock too soon.  Why?  Because selling a stock that has gone up in value — even when it makes sense to keep holding it — locks in our gain, which is one way to deal with the fear that a sudden drop in price will turn a winner into a loser

Over the long term, the disposition effect is responsible for a great deal of lost profit: instead of buying and selling rationally, we end up holding on to losers and selling our winners.

A more rational strategy is to perform a regular assessment during which we set aside our feelings and take a frank look at our investment portfolio.  At that time, we can evaluate each stock and — regardless of the history of the stock’s price — ask the question: Right now, is this stock worth owning?

This allows us to identify the stocks we should not own any longer, so we can sell them and invest the money in holdings with more growth potential.  Because of the disposition effect, however, making such impersonal decisions can be difficult.

If you study investors who have long-term success, you will see that they have learned how to overcome the disposition effect.  This enables them to jettison losers as quickly as possible and keep winners long enough to develop to their full potential.

To make it easier for yourself, when the time comes to evaluate your holdings, I suggest that you remember the following principle.

Harley’s Rule of Investing #5: Ignore what you feel; buy and sell when it makes sense to do so.

Sunk-Cost Effect: When you spend money that cannot be recovered, economists refer to it as a “sunk cost.”  For example, let’s say a company budgets $100,000 to develop new software for internal use.  After three months, they have spent $25,000.  The $25,000 is a sunk cost, because it can never be recovered.

As a general rule, it is best to ignore sunk costs when you make investment decisions.  What’s done is done: Changing the future can’t change the past.  Nevertheless, it is common for investors to be influenced by sunk costs, a cognitive bias referred to as the “sunk-cost effect.”

Being aware of the sunk-cost effect can save you a lot of money.  In the example above, let’s say that, after three months, the managers of the company developing the software realize that it will never actually do what they need.  However, they choose to maintain the project because they have already “invested” $25,000.  This is the sunk-cost effect.  (A sadder example would be an engaged couple with serious misgivings, who agree to go through with their marriage because they have already spent a lot of nonrefundable money on the wedding.)

As an investor, sunk costs should never influence your decisions.  When you see a loss, do your best to refocus on your goal and make the best decision you can, assessing the situation as rationally as possible on its own merits.

Example: You have spent $10,000 on Stock A, which then drops in price to $7,000.  However, you believe that you can make more money by selling Stock A and buying Stock B.  Since your goal as an investor is to make as much money as possible, the best decision is to make the change, even though it means acknowledging a sunk cost of $3,000.

Harley’s Rule of Investing #6: Once money is gone, you can’t get it back — so don’t try.

Anchoring: It is common to find ourselves relying on only one specific item of information when making a decision.  In such cases, the information is called an “anchor.” The tendency to rely too much on an anchor, and thereby make an irrational decision, is a cognitive bias we call “anchoring.”

For example, let’s say that a month ago you were thinking of buying a particular stock that was selling for $150/share.  However, you decided to wait.  Since then, the stock has declined to $100/share.  If you use the previous price of $150 as a reference point (an anchor), the current price looks like a bargain.  However, if you depend only on a price comparison, you are neglecting to answer the real question: If you buy the stock at $100/share, is it likely to be a profitable investment?

The moment we buy a stock, the price becomes an important number.  After all, what we paid will ultimately determine how much money we will make or lose on the investment.  However, if we let the purchase price become an anchor, it will influence our decision-making, and predispose us to the disposition effect we discussed earlier: the tendency to wait too long to take losses and to move too quickly to realize gains.

Anchoring leads to distorted thinking because our emotions and our intuition make it easy to use the anchor as a reference point.  Instead, we would be better off making a more logical analysis, independent of previous costs or gains.

No one can guess perfectly, and over time, every investor learns that not all of his investments are going to make money.  From time to time, it is important to be able to recognize a loss, close out the investment, and move on.  If you can make more money selling a stock than keeping it, you should sell it, regardless of how much money you paid for it.  There is no reason to consider what you paid for something when you are trying to decide whether or not to keep it.  Let me embody this guideline in the form of a rule:

Harley’s Rule of Investing #7: The stock doesn’t care what you paid for it.

To be continued …