Everybody has reactions. Especially when it comes to money.
– Lock, Stock and Two Smoking Barrels (1998)
All investors – from day traders to mutual fund portfolio managers – hate to lose money. The most hated loss is a realized one – when an investor sells a stock for less money than he or she paid for it.
A key insight of Behavioral Finance is that the hatred of realized losses is so strong that it leads investors to hold onto unrealized losses for longer than they should and conversely, to sell winning investments too soon. Economists term this tendency the “disposition effect” and the economic framework that defines it was first formalized by Daniel Kahneman and Amos Tversky in their seminal 1979 paper, Prospect Theory.
It should come as no surprise that the disposition effect is damaging to investment returns—it’s hard to make a successful investing career with a hold-your-losers-cut-your-winners-short strategy.
What will be a surprise are the results of new research from Cary Frydman at USC’s Marshall School, Chicago Booth’s Samuel Hartzmark, and the Marshall School’s David Solomon that show the complex way investors trick themselves to avoid falling prey to the disposition effect.
According to the team’s research, investors avoid suffering the psychological pain of a realized loss by immediately reinvesting in another stock after selling a losing one. Investors still keep track of the high-water mark from the losing investment in the back of their minds, but conceive of the sale of the first stock not as a realized loss but rather as “rolling” capital into a different, related investment. The act of reinvesting makes them more willing to part with a losing stock earlier, thereby sidestepping one element of the disposition effect.
But as human decision makers, we can run but we can’t hide. It turns out that the investors studied tended to roll their capital into stocks that were more volatile than those from which they rolled out. This finding is precisely what Prospect Theory predicts should happen when an investor is losing; namely, they increase risk-seeking strategies to attempt to win back a loss.
Frydman’s team also found that the opposite was true: when investors sold stocks and did not reinvest, they tended to sell too soon. Again, this observation agrees with Prospect Theory’s prediction that investors become risk averse when they are winning.
Interestingly though, the team found that investors waited until they were “made whole” on the original investment before becoming risk averse and selling the stock they had rolled into. This means that they had kept track of what “winning” and “losing” meant in relation to a series of investments rather than in terms of an investment in a single stock.
These results were discovered using data from individual investors’ transactions, but the team also used mutual fund transaction data to see if institutional investors operated in the same way. Indeed, they found that professional investors were subject to the same tendencies as their amateur brethren.
This paper underscores that human decision makers are not the hyper-rational, utility-maximizing “Econs” that the University of Chicago’s Richard Thaler describes in his book Nudge. Hartzmark’s research is exciting in that it demonstrates the complexity involved in making investment decisions and quantifies the degree to which behavioral biases affect all investors.