The Psychology of Mistakes

09/25/2002 12:00 am EST


Steven Halpern


“I have not failed,” said Thomas Edison.  “I’ve just found 10,000 ways that won’t work.”  In investing, mistakes are a part of the game.  The mark of a successful investor is the ability to understand one's mistakes and learn from them.  But doing so is easier said than done.  Indeed, accepting our mistakes can go against our natural inclinations.

The premise of Upgrading is simple: sell the losers and buy the winners,” says Janet Brown, editor of No-Load FundXa top-performing mutual fund advisory service that focuses on shifting its holdingsknown as Upgradingto those funds which have shown the best performance over the previous 1, 3, 6, and 12 months periods. “But if Upgrading is so easy, why don’t more investors do it? Even regular Upgraders sometimes find themselves holding on to a dog of a fund when our rankings clearly tell them to move on. How is it we can become emotionally attached to an investment when logic tells us to sell it and move on to a better choice?

Research in behavioral finance, which combines economics with psychology, tells us that investors often choose the alternatives that provide them with emotional solace rather than the ones that offer economic benefits. Studies show that investors are far more likely to sell their winning funds or stocks, while holding on to their losers. The technical term for this phenomenon is the disposition effect and it’s an example of what psychologists term loss aversion. People are keen to avoid the remorse that comes from having made a wrong decision. They hang onto hope that they’ll eventually recoup their losses. As long as they don’t sell the losing investment they needn’t acknowledge the loss and experience regret. Meanwhile, they console themselves by noting they have only a ‘paper’ loss.

Professor Terrance Odean, while a researcher at U.C. Davis, examined 10,000 brokerage accounts between 1987 and 1993 and discovered that investors realize their gains more readily than their losses. Moreover, he observed, ‘The winning investments that investors chose to sell continue in subsequent months to outperform the losers they keep.’ A later study by Odean and two colleagues found that investors are twice as likely to sell a winning fund than a losing fund, with nearly 40% of sales made in funds ranked in the top quintile of previous year’s returns. Less than 15% of all sales were in funds ranked in the bottom quintile. It’s no wonder that money pours into funds with good performance, but only dribbles slowly out of lousy ones. Clearly, there are different forces at work when investors decide to buy a fund than whey they decide to sell.

Research has also shown that regret triggered by inaction is less severe than that generated by action. Here’s an example:  Investor 1 owns the XYZ fund but decides to sell it at the start of the year to switch to ABC fundbut he never acts on that decision. At the end of the year he learns he would have been wealthier had he switched to ABC, which outperformed XYZ. Investor 2, on the other hand, holds fund ABC at the start of the year and decides to switch to fund XYZand does so. At the end of the year, he discovers he would have been better off had he stayed in fund ABC.

Which investor feels more regret? Both experienced the same performance. But research shows that Investor 2 would be kicking himself much harder than Investor 1. We tend to regret action more than inaction, leading us to favor the status quo. This prevents us from making changes that would likely lead to positive outcomes.

These are powerful psychological influences that affect the behavior of even the most rational among us. It might help to remind ourselves that when we follow Upgrading, we know that any fund we buy will eventually be marked for a sale. Because market leadership is continually rotating it is inevitable that we will be prompted to make a switch. The only question is when. When it comes time to sell, we needn’t regret a decision that was based on the information available at that time, even when new information leads us to a new decision.

It’s important that we remain willing to examine our own investment behavior and avoid the pitfalls brought on by common psychological quirks. Reason and emotion are often at odds.  Remember, we’re not just investors, we’re also human.

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