Managing the Disposition Effect

I’ve written about why the disposition effect matters in an earlier post. Now it’s now time to consider what we can do to manage it. We can learn to manage the disposition effect if we:

  • Develop a personal investment philosophy
  • Improve our self awareness by keeping a diary
  • Promote discipline of sticking to our investment process by using checklists
  • Establish a sell discipline
  • Shift our focus away from losses
  • Focus on the key factors supporting our investment thesis instead of the stock price

What do you stand for?

If you don’t stand for something, you’ll fall for anything – Gordon A. Eadie

How can you select an investment strategy that’s right for you? The first step is to decide on a set of personal investment beliefs. They must be personal. We are far more likely to stick to conclusions that we arrive at through our own logical reasoning and research. In other words, we need to take the time to convince ourselves that we are comfortable following our chosen strategy.

Having conviction in our beliefs requires finding the answers to questions such as:

  1. What are my risk and return objectives? *
  2. What is my investment horizon? *
  3. Which investment risks am I rewarded for?
  4. Is it possible for me to beat the market?
  5. How and when should I diversify?
  6. How much should I be willing to pay in fees and costs?
  7. How should I define, measure and manage risk?
* Questions 1 and 2 relate to investment objectives and not investment beliefs.

The term “belief” accepts that there are few objective truths in economics and finance. Investors choose to interpret the way in which markets function and the reasons why other investors behave the way they do.

Beliefs are statements that articulate how we will try to achieve our investment objectives. They are based on observations of how markets function and how investors behave. Investment beliefs accept the reality that economics and finance cannot be captured in hard, predictive models. Instead, they encompass a view on how (other) market participants learn or fail to learn or on how financial markets will function in the future.

Failure to define a clear investment philosophy results in poor investment outcomes as Professor Aswath Damodaran of NYU Stern School of Business explains:

The absence of a core philosophy has two predictable consequences: (a) a lack of consistency, where active investors veer from one strategy to another, often drawn to whatever strategy worked best during the last time period (emphasis added) and (b) me-tooism, as they chase momentum stocks to keep up with the rest.

It’s important to identify and stick to a strategy that you: a) have chosen based on reasonable expectations of risk and return identified through research and experience and b) suits your personality.

Self-Awareness is Crucial

Answering the seven questions above requires self-awareness. It requires thinking deeply about our personality and how we react to different situations. For example, it means answering questions such as:

  • Am I impatient or anxious?
  • Do I seek the approval of others before making decisions?
  • Do I always need to be right?
  • How do I cope with uncertainty?
  • How do I react to losses?
  • Do I get a thrill out of trading?

Experience has taught me that finding the “right” investment strategy is similar to finding the right diet – its pointless if you can’t stick to it. Your diet’s never going to work if it requires you to cook each day but you work long hours and find it hard to make the time to prepare meals.

For example, a value investing strategy looks for companies that appear to be cheap relative to the intrinsic value of their assets or earnings. Sounds good, after all who doesn’t like the idea of finding a bargain?

But  value investing often requires patience. It can take several years for the stock price to eventually reflect the underlying value of a company. It may require a willingness to take a contrarian view. Stocks are rarely cheap without reason or a problem that creates uncertainty.

Consequently, value investing is not suitable for someone that is impatient, has a short-term investment horizon, or is reluctant to go against the crowd by owning out of favor companies.

Using a strategy that doesn’t fit your personality, objectives and ability to tolerate risk significantly increases the risk that you will fall prey to the disposition effect.

Keep a Diary

Elite athletes improve by creating feedback and learning from it. Whether it’s watching a tape of the game, or checking the output of wearable body sensors post match, athletes always take the time to look for feedback. Think about it, how else can an athlete identify the areas that they need to work on to improve their performance?

In a similar way, we need to create feedback that we can study to improve our performance as investors. And there is no better tool than keeping a diary.

Unfortunately all of us have selective memories. We naturally fall into the trap of exaggerating our successes and minimizing our failures. We attribute winners to our brilliance and losers to bad luck.

This is where a diary comes into its own. It allows us to confront our decisions as they were, not how we remember them later.  Writing things down creates the feedback that we can use to improve.

What should we include in our investment diary? The short answer is any information that will help us to identify patterns in our behavior and decision making. This might include:

  • Investment thesis – the reasoning behind the investment decision.
  • Portfolio allocation and fit – how much are we willing to invest? How does this investment improve our overall portfolio?
  • Risk limit – how much are we prepared to lose?
  • Success factors – how will we know if we’re right?
  • Failure factors – how will we know if we’re wrong?
  • Our emotional and physical state

Your dairy notes can also be used to create a “story” for each stock , a technique that the legendary fund manager Peter Lynch used to beat the market by a huge margin. We’ll pick up the idea of how creating a story can help manage the disposition effect again later in this post.

Use a Checklist

Checklists are also an important tool for managing behavioral biases. Checklists promote consistency. They help us to avoid two behavioral traps:

  • Inconsistent weighting of relevant factors due to emotion or circumstances.
  • Skipping important steps in our investment process.

How might we fall into the trap of inconsistency? Suppose that our investment philosophy is to invest in quality companies at reasonable prices. We consider two companies for investment, company ABC and XYZ. The fundamentals of company ABC are:

  • P/E ratio = 15x
  • RoE = 12%
  • Forecast sales growth = 7.5%
  • Debt-to-total capital = 10%

And the fundamentals of XYZ are:

  • P/E ratio = 25x
  • RoE = 24%
  • Forecast sales growth = 12.5%
  • Debt-to-total capital = 30%

ABC is cheaper, but XYZ is twice as profitable. ABC has a more conservative balance sheet (lower debt) while XYZ has faster forecast earnings growth. Which company should we chose?

Unfortunately, what ends up happening is that we assign different levels of importance to each of the factors over time. For example, we may place more emphasis on cheaper valuation during periods where the valuation of most companies are expensive. We may pay more attention to sales growth during periods where economic growth is slow. Or we may focus more on debt levels during periods of rising interest rates.

In other words, on any given day we might make a different choice, not because the companies have changed, but because we have. An inconsistent process will result in inconsistent performance. 

Two resources that ca help you to create your investment checklist are:

Follow the Rules

Selling at a loss is always hard. That’s why most professional investors develop a sell disciple or a set of rules that must be followed. An example might be a rule that states that a stock must be sold when a loss reaches a predetermined percentage of the purchase price or of the value of the overall portfolio.

Such rules are designed to help the investor make decisions that are right on average and over time. In other words, no rule will work 100% of the time. But that’s OK. The purpose of a sell disciple is not to win on every trade. Rather, it is to prevent a large and permanent loss of capital.

The famous “boy plunger” Jesse Livermore wrote in his book How to Trade in Stocks:

Profits always take care of themselves, but losses never do. The speculator has to insure himself against considerable losses by taking the first small loss. In so doing, he keeps his account in order so that at a future time, when he has a constructive idea, he will be in a position to go into another deal, taking on the same amount of stock as he had when he was wrong.

Once again, there is no one-size-fits-all sell discipline. We each have to develop a set of rules that are consistent with our objectives, investment strategy and risk tolerance. In their paper on the disposition effect, professors Hersh Shefrin and Meir Statman provide an example of one trader’s rule and the reasoning behind his rule:

I have a hard and fast rule that I never let my losses on a trade exceed ten percent… Some guys have a five percent rule. Some may have fifteen. I’m a ten man. The thing is, when you’re right you’re making eighths an quarters. So you can’t take a loss of a point. The traders who get wiped out hope against hope… They’re stubborn. They refuse to take losses… When you’re breaking in a new trader, the hardest thing to learn is to admit that you’re wrong. It’s a hard pill to swallow. You have to be man enough to admit to your peers that you’re wrong and get out. Then you’re alive and playing the game the next day.

There are 3 key points to note in this quote:

  1. Your wins have to be bigger than your losses, otherwise you won’t make a profit. And the easiest way to create a positive asymmetry between winners and losers is to keep your losses under control.
  2. Hope is not an investment strategy.
  3. The emphasis is risk management. Survival is always the first priority.

Sidestepping Mental Accounting

Changing the way we think about losing stocks can make them easier to cut. In other words, we can side-step the mental accounting and narrow framing by redefining the sale of a losing stock.

What are mental accounting and narrow framing? Here’s a description from my earlier post on the disposition effect:

We open a new mental “account” each time we purchase an investment. We then focus on the performance of each account, rather that the performance of our portfolio as a whole. This is known as narrow framing. Shefrin and Statman suggest that selling a losing stock is hard to do because we perceive this as closing our mental account at a loss.

We can bypass mental accounting by reclassifying the reason for the sale. Shefrin and Statman cite the example of transferring (selling a loser and simultaneously investing the proceeds in an other opportunity) between investments:

Gross’ suggestion to “transfer your assets” seeks to overcome the major obstacle standing in the way of loss realization, namely the need to close a mental account at a loss. A client who transfers his assets does not close his original mental account, and therefore does not have to come to terms with his loss.

Essentially, we are tricking ourselves into not paying too much attention to the loss. In this case, the trick has the positive effect of helping us to get over the inertia that makes it hard to realize a loss.

Other ways to do this include setting deadlines (e.g. selling a stock if it hasn’t performed as expected after 2 years) or looking for opportunities to execute a tax swap.

Check the Story, not Performance

In his book One Up on Wall Street, Peter Lynch recommends creating a story for each company that we invest in. Lynch explains:

Before buying a stock, I like to be able to give a two-minute monologue that covers the reasons I’m interested in it, what has to happen for the company to succeed, and the pitfalls that stand its path… Once you’re able to tell the story of a stock to your family, your friends… and so that even a child could understand it, then you have a proper grasp of the situation.

Why create a story? For three important reasons.  Firstly, to understand what you’re invested in and why. Secondly, to identify the key drivers of success and failure so that you can keep track of them.

The decision to hold a stock should be based not on the desire to realize a profit. We shouldn’t be too hasty to sell a stock if the company continues to deliver on its story.

Its surprising just how few companies actually create value for their shareholders. For example,  Alpha Architect (one of my favorite blogs for keeping up-to-date with academic research) recently cited a study by Hendrik Bessembinder at Arizona State University showing that from 1926 -2015 “the entire gain of the US stock market since 1926 is attributable to best performing four percent of listed stocks.

So if we’re lucky enough to find a company that can compound its earnings, selling it simply to “lock in” a profit is a dumb idea.  There’s a very high probability that the next stock we buy won’t be as good.

Thirdly, focusing on a story, i.e. company fundamentals and the factors that influence them, also helps not to focus too  much on the current share price or historical performance (our mental account).

How can I create an investment story? Professor Aswath Damodaran lists the steps involved in creating an investment narrative in the diagram below taken from his blog post Narrative and Numbers: How a number cruncher learned to tell stories!

narrative-to-number-steps

In summary, the tools that can help us to better manage our behavior and improve the quality of our decision-making are:

  • Investment beliefs.
  • Keeping a diary
  • Using a checklist
  • Following a strict sell discipline
  • Avoid focusing on losses
  • Follow the story instead of the stock price

Other posts on Behavioural Finance:

 

Feature Image courtesy of the Online Trading Academy

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