We Are Often Our Own Worst Enemy

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Reduce the Size of Your Gains and Increase the Risk of Losing?

That doesn’t sound like a very wise strategy. Certainly none of us, the fully informed profit seeking machines we are, would become more aggressive when we are faced with a potential loss and then get shy when a gain is on offer. Well this is something that we all have to constantly guard against. Economic theories tell us that we should not act in this manner. Studies show that we in fact, by our very nature, cut our winners short and take huge risks in order to avoid a small loss today.

Modern Portfolio Theory (MPT) burst onto the scene starting in the 1950’s. At its core MPT says that investors all look to maximize returns for any given level of risk. Nobel prizes were awarded to the leaders in the field. This was an academic exercise taken on by economists. Several assumptions were made in order to make their case. These are some of the assumptions made in formulating the core of MPT: all investors have access to the same information at the same time, all investors are rational and investors have an accurate conception of possible returns. The school of thought is based on the fact that the market is brutally efficient at all times and that investors, in order to maximize the “utility” of their investment decisions, should also be brutally efficient. Utility is a term to measure the balance between risk and return. You maximize utility by generating the highest possible return for any given level of risk. There are several assumptions made in any theory. The advances made by MPT have had a profound impact on how assets have been managed for half a century.

As I said, Nobel prizes were awarded for the development of these theories. Harry Markowitz was a leader in this field of study and received a Nobel Prize in Economics for his work. William Sharpe, James Tobin and Eugene Fama are some of the other leaders in MPT and the development of such concepts as the Efficient Market Hypothesis and the Capital Asset Pricing Model (CAPM), for example.

I don’t know about you but at times I can be less than brutally efficient. Also, I can’t be certain, but I do not think I have access to all the data that every other market participants has. While the theories put forth by MPT can be very useful some of the assumptions are rather farfetched.

In 1979 two sociologists, Daniel Kahneman and Amos Tversky wrote a paper called Prospect Theory: An Analysis of Decision Making under Risk. Kahneman received a Nobel Prize for his work. They thought that we needed to look at how people search for utility in the real world and how we all balance risk and reward. These gentlemen thought MPT made far too many unrealistic assumptions. They worked to try to explain why we make irrational economic decisions. They posed several questions in various parts of the world. At its core the study showed that for many of us the pain of a loss outweighs the joy of a gain.  This fact influences the way we all make investment decisions. Unfortunately, the attempt to balance joy and pain in our investments often leads us to make decisions that limit gains and increase losses. Since we feel less joy from a gain we take less risk in the domain of gains. Since we feel the pain of a loss so deeply we will act to avoid losses. This fear of losses often times leads us to take on more risk in the domain of losses. This is the opposite of what we would all say we would do. In any case, people will often go to great lengths and take on great risk to avoid the pain of a loss today.

Prospect Theory was developed by asking people a series of questions. When a question was posed in the form of searching for gains, people value certainty. In general we will take the sure thing instead of an investment with a greater risk adjusted potential reward. We will accept a lower certain return instead of a higher return that is just probable. When a question is posed in terms of avoiding a loss, people will actually take on more risk to avoid the pain of loss. They will in practice choose a direction that increases the risk of outsized losses in order to avoid a certain and smaller loss. They will avoid a certain loss today and take on huge risks in an investment that has a far larger potential loss. MPT tells us that we should maximize potential return for any given level of risk. Prospect Theory shows us that we reduce utility when we are searching for gains and again reduce utility when we have investments that have gone down in value. 

How does this play out in real life? Let’s come up with some scenarios I am sure we all have seen in our own portfolios. We recently bought two stocks. Stock A is up 10%. Stock B is down 10%. Let’s be brutally efficient here. The market is telling you A is a winner and B is not in favor. Many of the most seasoned successful investors will step in now and sell B and take the certain manageable 10% loss. They will hold A. A has worked and hopefully it will be a huge homerun. 

However, many of us find the thought of selling at a loss to be simply unacceptable. We don’t invest money to lose it! We will often take the certain small 10% gain by selling stock A. We will take the smaller certain return right now in A. We will act in a risk averse way in the domain of gains. We search for that certainty and sell a winning stock today that may have a far larger potential return.

So, we sell the winner and hold onto stock B which is down. There will be a certain loss of 10% if we sell today.  Often times we will avoid that certain loss and take on more risk. The prospect of the 10% loss is so unattractive we will take on the risk of a far larger potential loss to avoid pain today. For many of us we repeat this several times over. We have been told “you can’t go broke taking gains.” You can if you consistently take small gains and manage to hold onto losers. Perhaps you do what many of us have done. You double up to catch up. You take the proceeds from the sale of stock A and buy more stock B. Come on you know you have all done this. Then B shows its true colors and really begins to spiral down. If you can’t sell it at a loss of 10% you sure as heck can’t sell it down 20%. People “manage” to turn a small loss into a far larger and painful loss. Maybe you should have sold B and bought more A!

You haven’t read too much from me about value versus growth investing. I think there is far too much debate on that and at the end of the day we are all searching for stocks that we think are going to go up. I think that if we took 10 different styles of investing and used those styles to pick stocks they all would, over time, pick enough winners to make us happy. I contend that how we manage names after we buy them will be the bigger determinant of success. Do we cut our losses and let our winners run? Do we sell for small gains to make ourselves feel good in order to avoid the pain of locking in certain losses that could develop into disasters?

If you read a couple of classic books on investing, Market Wizards and New Market Wizards, for example, they can help you greatly. These books were simply interviews with hugely successful investors. The subjects of the books have wildly divergent backgrounds and invest in different markets with different styles. Many of the subjects fell on their faces and suffered sustained losses at the outset of their careers. There is one common theme in all of their stories. They all saw substantial improvement in their returns when they became adept at managing the downside. When they became brutally efficient at selling today's certain small losses before they became big problems, they became far more effective investors. When they combined the discipline to keep losses small with the patience to allow winners to run they became Market Wizards. They fought to avoid the impacts of Prospect Theory that influence all of us. They combined sound technical and fundamental analysis with the discipline to avoid negative behavioral biases to generate superior results.

The next time we are faced with a decision to buy or hold, how efficient are we going to be? ”I’ll sell when it gets back to break even.”  “When it gets back to $50 I’ll sell it.”  If you find yourself making comments like these you are likely just swapping today’s little bump in the road for tomorrow’s potential disaster. Let your winners run and sell your losers. On top of that, when the overall market gets hit and your winners give back part of their gains buy more of them. 

Be systematic and disciplined when making your decisions to buy stocks. Maintain that same discipline after you have constructed your portfolio. Your allegiance is to your discipline and your overall portfolio not any one stock in particular. Avoid the pitfalls presented by Prospect Theory and follow your drill.

Source: PFS Group

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About Thomas J Smith CFA