Unholy Trio Emotional Investing Traps That Kill Your Returns

Post on: 17 Апрель, 2015 No Comment

Unholy Trio Emotional Investing Traps That Kill Your Returns

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Few know more about the snares of emotional investing than Elizabeth P. Anderson, CFA. She is the founder of Beekman Wealth Advisory LLC, a New York boutique financial consultancy providing highly customized portfolio management and wealth education services to high and ultra-high-net worth families and individuals. Her advice:

Whether the market climbs, as it has recently, or drops, the danger is that you let emotions guide your investing. How can you avoid that trap, and base your investment decision-making instead on rational considerations?

You have likely heard a lot about behavioral finance, which spotlights the mental shortcuts and other emotion-driven patterns that too often lead to bad decisions.

If you don’t specialize in investing, however, you may wonder what is so different about behavioral finance – and more importantly, why you as an investor should even care. After all, is there anything useful you can actually do with this newfound knowledge?

Plenty. Harnessing the insights of behavioral finance generally requires a conscious effort to combat this pervasive will to believe. Becoming a better investor requires, above all, the willingness to step back and evaluate critically one’s own prospective investment decisions. The goal of this evaluation is to promote a pattern of acting rationally, rather than reacting emotionally.

Let’s explore three examples of emotional investing:

1. Keeping a losing stock. Consider an investor holding stock in XYZ Co. purchased at $50 per share and currently trading at $40. That is, this investor is holding a security with an unrealized loss of 20%.

This situation is likely to trigger a behavioral bias called loss aversion. The emotional investor hangs on in hopes of a stock price rebound, aiming to avoid the pain of a realized loss. The rational investor, on the other hand, has a lengthier and much more deliberate mental process, attempting to calculate the expected relative value of selling, versus holding the losing position.

If the investor sells, this locks in a loss, but one that is less than 20% after taxes. That is because the loss, once realized, can offset the taxable gains on winning securities. For example, at a capital gains tax rate of 20%, the after-tax loss is 16%, rather than 20% (the value of the tax offset benefit is 20% times 20% = 4%). Therefore, after the tax benefit, the value of selling the position is $42 of effective after-tax proceeds generated for reinvestment.

The rational investor tries to determine whether holding the current $40 stock is likely to yield a better result than reinvesting these after-tax proceeds. This depends critically on the likelihood and magnitude of the price recovery in the current stock. That, in turn, depends on questions such as why the stock price declined in the first place, and what must happen for it to rise again.

Unholy Trio Emotional Investing Traps That Kill Your Returns

A 20% decline in a bank stock price during the fourth quarter of 2008 suggests the bank is unusually strong, in a time many bank stocks fell 50% or more. A 20% decline in a consumer electronics stock during a strong bull market, on the other hand, might be a sign of poor management or obsolescence in the product line. Holding onto the bank stock, but selling the electronics stock, might be the more rational course.

2. Holding just one stock. Consider an investor whose entire portfolio is dominated by the securities of one company. She owns its shares outright; she owns options to buy more shares; and her 401(k) plan at work is stuffed with the same shares. And depending on the future path of the stock price, she might keep her job — or not.

This may sound extreme, but this situation describes many real-life investors during the late-1990s technology bubble. They were employees of recently public technology companies. Their compensation, the value of their financial assets and their livelihoods all depended on their employers’ future success. But some of those companies weren’t much more than an idea.

Why did so many employees hold onto large proportions of employer securities rather than diversifying? They had a greater familiarity with their employers, versus other companies. These investors, often young and without investment experience, fell into the bias of aversion to ambiguity.

A rational investor, however, uses a technique called reframing. meaning changing one’s mental starting point. Rather than a mental starting point of, say, $10 million worth of pets.com stock and stock options, she starts from an assumed pile of $7 million in cash (or whatever the after-tax proceeds of cashing in the stock and options is). Would she, in that circumstance, choose to put her entire portfolio into that one stock?

For most people, this reframing moves them toward a rational investment decision, which is to sell off at least some of the employer securities to diversify into other assets.


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