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April 19 - July 7, 2018
If they sold their losing stocks, they would realize the painful effects of regret and loss.
Extreme loss aversion helps explain sellers’ reluctance to sell their properties at a loss.
Behavioral-finance theory also helps explain why many people refuse to join a 401(k) savings plan at work, even when their company matches their contributions. If one asks an employee who has become used to a particular level of take-home pay to increase his allocation to a retirement plan by one dollar, he will view the resulting deduction (even though it is less than a dollar because contributions to retirement plans are deductible from taxable income up to certain generous amounts) as a loss of current spending availability.
Two suggestions have been made to overcome people’s reluctance to save.
Thus far we have considered the cognitive biases that influence investors and, therefore, security prices. The actions of individual investors are often irrational, or at least not fully consistent with the economist’s ideal of optimal decision making.
the second major pillar on which some behavioralists rest their case against efficient markets is that such arbitrage is severely constrained.
The market can remain irrational longer than the arbitrageur can remain solvent.
A study by Markus Brunnermeier and Stefan Nagel examined hedge-fund behavior during the 1998–2000 period to see whether these funds restrained the rise in speculative favorites.
The findings were surprising. Sophisticated speculators such as hedge funds were not a correcting force during the bubble period. They actually helped inflate the bubble by riding it rather than attacking it.
They were playing the game described earlier in Keynes’s famous newspaper beauty contest. While a stock selling at $30 might be “worth” only $15, it would be a good buy if some greater fools would be willing to pay $60 for the stock at some future time.
We have just seen how various aspects of human behavior influence investing. In investing, we are often our worst enemy. As Pogo put it, “We have met the enemy and it is us.” An understanding of how vulnerable we are to our own psychology can help us avoid the stupid investor delusions that can screw up our financial security.
These insights about investor psychology can keep you from being the patsy.
The first step in dealing with the pernicious effects of our behavioral foibles is to recognize them.
Don’t be your own worst enemy: Avoid stupid investor tricks. Here are the most important insights from behavioral finance.
Any investment that has become a topic of widespread conversation is likely to be especially hazardous to your wealth.
Invariably, the hottest stocks or funds in one period are the worst performers in the next. And just as herding induces investors to take greater and greater risks during periods of euphoria, so the same behavior often leads many investors simultaneously to throw in the towel when pessimism is rampant.
Even without excessive media attention, large market movements encourage buy and sell decisions that are based on emotion rather than on logic.
Chasing today’s hot investment usually leads to tomorrow’s investment freeze.
Behavioral finance specialists have found that investors tend to be overconfident in their judgments and invariably do too much trading for their own financial well-being.
Remember the advice of the legendary investor Warren Buffett: Lethargy bordering on sloth remains the best investment style. The correct holding period for the stock market is forever.
Selling your winners will add to your tax burden.
My advice is that you should not buy IPOs at their initial offering price and that you should never buy an IPO just after it begins trading at prices that are generally higher than the IPO price.
Stay Cool to Hot Tips.
Tips come at you from all fronts—friends, relatives, the telephone, even the Internet.
Don’t go there.
Distrust Foolproof Schemes.
In the long run, though, I agree with Bernard Baruch, a legendary investor of the early twentieth century, who said, “Market timing can only be accomplished by liars.”
And don’t count on the regulators to protect you from such fraudulent schemes.
It is important that investors be aware of the strengths and weaknesses of “smart beta” strategies and the role they might play in their investment plans.
It shows why “smart beta” flunks a safety test, and why it is not as smart as it claims to be.
Now what the “smart beta” investment managers would have us believe is that pure indexing, where each company has a weight in the portfolio given by the size of the company’s total capitalization, is not an optimal strategy.
The trick is to tilt (or flavor) the portfolio in some direction such as “value” versus “growth,” smaller versus larger companies, relatively strong stocks versus weak, and low-volatility stocks versus high-volatility ones.
I have considerable intellectual sympathy with this approach.
Never forget that low P/E multiples and low price-to-book-value (P/BV) ratios can reflect risk factors that are priced into the market.
Nevertheless, we need to remember that small firms may be riskier than larger firms and deserve to give investors a higher rate of return.
All “smart beta” strategies represent active management rather than indexing.
To the extent that “smart beta” funds do generate excess returns, it is most likely because they are assuming greater risks.
“Smart beta” portfolios do not produce alphas.
“Smart beta” funds and ETFs also carry considerably higher management expenses than traditional capitalization-weighted index funds.
Mutual funds (and ETFs) designed to capture momentum and low-beta effects have not demonstrated superior performance.
Finally, many of the “smart beta” ETFs are more costly to buy and sell than their traditional cap-weighted brethren.
Many “smart beta” ETFs follow nonstandard indexes that are far more difficult to hedge against. Hence, their prices are more likely to deviate from fair value and often trade at significant premiums or discounts from the value of their underlying holdings.
If you need further discipline, remember that the only thing worse than being dead is to outlive the money you have put aside for retirement. And if projections are to be believed, about one million of today’s baby boomers will live to be at least one hundred.
Assuming that you are protected by medical and disability insurance at work, this reserve might be established to cover three months of living expenses.
Moreover, any large future expenditures (such as your daughter’s college tuition bill) should be funded with short-term investments (such as a bank certificate of deposit) whose maturity matches the date on which the funds will be needed.
Most people need insurance. Those with family obligations are downright negligent if they don’t purchase insurance.
People need to protect themselves against the unpredictable.
For individuals, home and auto insurance are a must. So is health and disability insurance.
You don’t need life insurance if you are single with no dependents. But if you have a family with young children who count on your income, you do need life insurance and lots of it.
For most people, I therefore favor the do-it-yourself approach.
