Investing Mindset – Staying level-headed
Prospect Theory Solutions to develop your investing mindset
i) Work out a stop loss level before committing to the trade and put in a stop loss at the time of entry AND learn to love to take the losses (because you are avoiding bigger losses) and hate to take the profits.
ii) Evaluate risk tolerance; what losses are you prepared to tolerate at the level of individual stock selection and at portfolio level?
iii) Diversification; write down your investment strategy, justify all investments in the context of achieving portfolio goals. This will reduce your emotional turmoil and impulsiveness.
iv) “Forget the past” – what you paid for the investment may have no bearing at all on the long-term value of the asset. Consider the movement in UK property values since the 1960s!
v) Pay less attention to investments (admittedly this has been more difficult in recent years).
One example might be to focus on monthly returns, i.e. how much cash does the portfolio generate per month? Does an additional investment augment or reduce monthly cash returns? In adopting prospect theory solutions, and essentially becoming a more passive investor, we need to be mindful of psychological effects of adopting solutions to prospect theory.
Broadly this encompasses the risk of “decision paralysis” which may manifest itself in three different biases:-
a) “Endowment effect”; owners tend to place a higher value on their portfolio assets than assets outside their portfolio. They tend to demand more to sell assets than they would be willing to pay for them. This frequently manifests itself if the asset is inherited and there is an emotional attachment to giving it up – “selling the family silver”.
b) “Status Quo Bias”; owners have a preference towards “doing nothing rather than doing something”.
c) “Attachment Bias”; willingness to hold onto something due to familiarity. This is a problem, especially when investing in companies that are also household names. It is important to remember that whilst you personally might like to shop at, and own shares in the company, your attachment might cause you to overlook that companies’ investment performance. Overcome these biases by asking “if I only have cash would I buy this asset?”
It is important to remember that whilst you personally might like to shop at, and own shares in the company, your attachment might cause you to overlook that companies’ investment performance. Overcome these biases by asking “if I only have cash would I buy this asset?”
The role of Confidence and Overconfidence; (Govt health warning: there is a sexist element to this!)
Bear in mind other psychological effects, in particular, the “Illusion of Knowledge”. Studies have shown this applies far more to men than women. Men tend to have narcissistic tendencies leading to overestimating their athletic abilities, leadership skills, investing and analytical insightfulness, and likeability/charisma.
They want to believe they know what they are doing and that others appreciate and love them for it!
As a result, the individual tends to search for confirmation of previously held beliefs, and ignore or turn a blind eye to bad news, hence “confirmation bias”. The arrival of the internet and the financial news gives greater access to information and makes it easier to tick boxes.
However, information overdose makes it harder to arrive at a relevant interpretation of that information. The more “confirmation” the decision maker gets the more confidence grows.
This overconfidence impacts decision making as it results in an exaggerated belief in an ability to control events, the “Illusion of Control”. This develops over time, as you become more familiar with investment markets.
It is typified by the remark; “I’ve been in the markets for over 20 years…. this sort of thing does not happen”. The more active the participation the greater the illusion of control. This leads to the risk of over-trading, an expensive activity that is a major cause of trading losses.
Studies into trade frequency suggest that men trade more frequently and have higher portfolio turnover (total value of bargains per annum/net portfolio asset value) but women are more careful in their approach. Annual Portfolio Turnover by Gender and Marital Status.
According to the above study, men have higher risk portfolios, trade more frequently and prefer volatile, high-beta and small cap investments. This suggests overconfidence. An overconfident investor needs a second opinion, on the investment and its impact on the portfolio and the precise process he has undertaken to arrive at a decision to buy/sell.
An overconfident investor should also monitor his own performance or have it monitored to judge investment selection skills more accurately.
A rational investor is one that does not suffer from overconfidence, undertakes research prior to making decisions and is knowledgeable about the portfolio’s overall rate of return.
Part 4 will be published on Monday 11th, next post will teach you about “cognitive dissonance” and a summary of all previous posts will conclude this behavioural psychology series. Don’t miss the final post!
If you’re new to the CSS Investments blog, please make sure you read our introduction post here to find out how this blog will help you become a better informed investor or trader.
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