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| Thinking Money |
Fiscal Feelings
John Ferry
03/01/2008
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Warren Buffett once said that
investing is not a game in which the guy with the 160 IQ beats the guy with the
130 IQ. "Once you have ordinary intelligence, what you need is the temperament
to control the urges that get other people into trouble," he concluded.
Over the past three decades, a subset of economic theory has
emerged that attempts to explain how and why emotions influence investors in
ways that make them appear to be irrational decision-makers. Known as
"behavioral finance," this field examines why most of us fall into the rather
vague "other people" category of Buffett’s analysis. "There was a sense that
standard finance models left too many puzzles, and that what you end up with is
a theory that does not square with the evidence," says Meir Statman, a professor
of finance at California’s Santa Clara University and an authority on behavioral
finance.
As an example of irrational decision-making, let’s say you buy
stock in a company because you believe it is underpriced, and that after
quarterly earnings come out, this anomaly will be corrected with a price
increase. However, your bet does not pay off. Quarterly results are worse than
expected, and actually lead to a decrease in the company’s value. A completely
rational investor would quickly take the hit, sell and move on. Yet you hang
on to the stock. "People still don’t know what this company can really do," you
tell yourself," and if I just give it another six months or a year, then my
initial assessment will prove correct."
The inability to realize a loss is one example of what
psychologists call a cognitive bias—a mental mistake. In a paper issued in 2005, Statman demonstrated how cognitive biases and emotions played a direct part in
Martha Stewart’s trading decisions. In 2004, Stewart was convicted of and served
time for obstructing justice and lying to investigators about a well-timed
stock sale. The papers that were entered into evidence at Stewart’s trial
included a statement that detailed her personal brokerage account holdings at
Merrill Lynch as of December 20, 2001. This showed that she was sitting on a
portfolio of 36 stocks, a number of which were technology stocks such as
Amazon.com and Cisco Systems. Twenty-three of these stocks showed unrealized
losses. Stewart had kept the stocks as their value fell, and only sold the ones
with unrealized losses in the week after the account statement was issued. She
then sold her shares in ImClone for a net gain, and it was this trade that led
to her conviction.
Statman traced Stewart’s trading activity and estimated that
her portfolio lost 47.4 percent of its value between June 30, 2000, and December
20, 2001. Stewart emailed a friend to say that the losses made her stomach turn. A rational investor would not have had this feeling, Statman argues, because he
or she would know that a paper loss is different from a realized loss only in
form, not in substance. The act of selling up does not change the underlying
value of a portfolio, but it does crystallize that value in the mind of the
investor.
Behavioral theorists argue that the reluctance to realize
losses stems from two cognitive biases. The first bias is known as faulty
framing. Normal investors do not mark their investments to market prices—they
cannot get the purchase price out of their heads once they have bought a stock.
Instead, they only mentally mark to market when they close a position. The
second bias is hindsight bias, in which investors think that events that have
taken place were actually fairly predictable—the "I knew all along" assertion.
This leads people to overestimate the predictability of the future.
A host of other biases can also affect the decisions we make.
Can they be overcome? A good starting point is self-awareness and understanding.
"Second," Statman adds, "we should realize that emotions and cognitive biases
are so ingrained in us that it is useful for the financial advisors to become
the second line of defense."
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