While there are many characteristics of a good investor, one is understanding your emotions and human tendencies. And on that note, even before you start looking at the stock market, I'd like to help you look at human tendencies and how they relate to investing, because they play more a role than you think.
The study of human behavior may teach you things you do not realize about yourself; things that once mastered, you'll be able to apply in a surprisingly large number of situations, even outside of investing.
Only after understanding your emotional responses to market movements and your natural inclinations should you move into the next phase: Analyzing and investing in companies. That's what I hope to do -- to show you the difference between subjective and objective decision making with investments and how, statistically, you are more likely to earn a higher return if you can invest objectively.
There is a concept
known as prospect theory, which was originally presented by Kahneman and Tversky in 1979. It holds that people do not respond equally to gains and losses. That is, they do not enjoy gains in the same magnitude that they dislike losses. Losses, the study indicated, are typically felt in a greater magnitude.
Additionally, every loss is felt separately (as are gains), not cumulatively. That is to say, it hurts a lot more to lose $500 twice, than it does to lose $1,000 once. If you had two stocks, would you rather have both down $500, or one down $1,000 and the other stable?
Now for the test: I will give you the choice between two coin flips:
Coin Flip No. 1: Heads you make $1,000, Tails you make $0. (a gamble)
Coin Flip No. 2: Heads you make $500. Tails you also make $500. (a certainty)
Before reading on, pick the one above that you would most likely choose.
Now I'll give you two different coin flip options, and you must choose one of them.
Coin Flip No. 1: Heads you lose $0. Tails you lose $1,000. (a gamble)
Coin Flip No. 2: Heads you lose $500. Tails you also lose $500. (a certainty)
In Kahneman and Tversky's original test, it would have been rational for any individual to choose either the gamble or the certainty consistently in both cases. However, the majority chose the guaranteed gain (Flip No. 2) first, and the gamble at losing nothing (Flip No. 1 for the second).
Because the pain of losing is by default greater than the joy of winning, people were more inclined to take the gamble to lose nothing, hence avoiding pain, yet more inclined to take guaranteed gain.
This theory can explain a certain type of behavior in investors, known as the disposition effect, which is the inclination of investors to hold on too long to stocks losing value, in hopes of recovering, and to sell stock rising in value too quickly, for fear of losing the gain.
This results in a negatively skewed distribution of stock returns, with small gains, and large losses. Because people inappropriately think of losses as only "real" if the investments are sold, there is a tendency to allow a higher degree of risk to avoid the pain of recognizing the loss. In the same vein, there is less tendency to "gamble" when an investment shows a gain, as it more preferable to take the guaranteed gain.
This is typical risk-averse behavior, but notice how the typical reaction is different in polar scenarios (gain vs. loss).
Get answers to financial questions on Wednesdays from our columnists who work in the financial services industry. John C. DeMoss, CFA, serves as president of DeMoss Capital. Submit questions to his attention by writing to Business Editor John Vass Jr., Chattanooga Times Free Press, P.O. Box 1447, Chattanooga, TN 37401-1447, or by e-mailing him at jvass@timesfreepress.com.