Study: Investors’ Beliefs – Not Preferences – Rule Their Investment Decisions
“Why didn’t I sell sooner?” is a common refrain heard from novice and experienced investors alike.
All investors have heard this before, whether from themselves or others. While missed opportunities should be used as ripe learning experiences, they are usually swept in the deep, dark corner of a mind and sworn to be forgotten.
However, this isn’t the full story when it comes to emotional investing.
What Causes Emotional Investing
As the markets rollercoaster, so do our emotions. Emotional investing occurs when investors’ emotions are presumed to be the force behind his or her actions, rather than a reasoned assessment of the facts. The tendency to sell winning stocks too soon and hold on to losing ones too long is called the disposition effect and has been previously well documented.
However, this effect alone doesn’t tell the full story – losses and gains aren’t all that motivate investors. A recent study out of Ohio State University challenges the long-held belief that emotional investing is not just about feelings and preferences towards winning and losing, but investors’ beliefs about a stock’s future.
We interviewed study co-author Professor Itzhak Ben-David, Assistant Professor of Finance at the Ohio State University Fisher College of Business, on whether the new study dispels traditional perspectives of what causes emotional investing:
“Our research attempts to identify the fundamental reasons that drive trading by individuals. In this study we test whether investors trade based on preferences, specifically, investors are averse to selling losers. We find little evidence that preferences towards realizing selling losers drive trading, on average. In contrast, our results show that the speculative motive seems to be a first-order driver for selling. These results dispel the common perception that whether a stock is in gain or loss is an important factor in investors’ decision making.”
Professors from Ohio State University and University of California, Irvine studied more than 77,000 accounts and their stock transactions at a large discount broker between 1990 and 1996, conducting a variety of unprecedented analyses. The professors observed when investors bought individual stocks, when they were sold, and lastly, how much was earned or lost with each sale.
But the professors could draw fewer conclusions around the investors’ specific feelings and preferences.
“We don’t learn about what they like or don’t like,” said Itzhak Ben-David, co-author of the study and assistant professor of finance at Ohio State University. “Surely, they don’t like to lose money — but their reasons for selling stocks are more complex than that.”
One simple way for the professors to question the theory that investors’ feelings are involved in trading is examining what happens when a stock is trading only a little bit higher or lower than the price paid. In keeping with the disposition effect, a small winner should lead to more sales than a small loser, right? Not entirely. The study found it was not clear, unlike the natural preferences of winning and losing would lead one to believe.
Moreover, if preferences were really the reason behind investors’ actions, then investors would not sell stocks losing value; however, the study noticed it was actually more likely for investors to sell losing stocks.
“If investors had an aversion to realizing losses, larger losses should reduce the probability they would sell, but we found the opposite — larger losses were associated with a higher probability of selling,” said Ben-David.
Another key finding of the study is the fact that men and frequent traders were more susceptible to sell winning stocks quickly to enjoy profits and sell losers just as fast to cut losses. The overconfidence associated with men and frequent traders leads them to trade on a belief-based system; they believe they have superior knowledge, and thus act accordingly. Which, of course, isn’t necessarily the best thing.
To read the full study, entitled “Are Investors Really Reluctant to Realize their Losses? Trading Responses to Past Returns and the Disposition Effect,” visit SSRN.
How To Avoid Emotional Investing
First, understand that money can simply be lost; it is a natural part of the risk-reward tradeoff. Because losing money is part of the game, the goal is always to deal with any and all loss in stride and stay objective along the way. Taking away the fear of losing money gives you room to rationally make the best decisions for your stocks. If you cannot spare to lose that money, you should not be investing it in the markets – since returns are not guaranteed.
Second, make and stick to a long-term investment plan. Planning to sell that particular stock next month, but doubting it as the date approaches? Remember: you made a plan for a reason. Evaluate whether your reason is still valid given the most recent company performance and market data, and act accordingly.
Third, make it easy for yourself. Regularly review your investments and rebalance: make the necessary changes to improve, and choose investments you can easily monitor and understand thoroughly. Emotions and beliefs are what make us human. But we don’t have to let them make us feel like we’re in the doghouse. Stay away from belief-based trading, and you’ll be flying as high as an eagle in no time.
Investing image courtesy of Shutterstock.