Human foibles and investment decision making
The house of fear has many windows. In this post I will take a look into some of those windows. Like many English words ‘fear’ has many meanings and nuances.
There are fear of financial loss, fear of failure, fear of being seen as foolish, fear of losing a gain, fear of getting whipsawed, fear based on vivid memories of recent events, fear of missing out, and so on.
When others are fearful
We can start with Warren Buffett: “We simply attempt to be fearful when others are greedy and to be greedy only when others are fearful.”
That’s the basic idea. But, the problem is understanding and addressing our own fears.
My current philosophy of buying and selling stocks has evolved over the years and continues to evolve. It is based on a number of developed instincts which I have internalized from a combination of reading about investment psychology and what I have learned in the school of hard knocks. As I say, the house of fear has many windows.
I would say that dealing with all these fears is a learned instinct. And frankly, it is an instinct that might take years to develop.
Greed and fear
It is often said that investors are mostly driven by greed and fear. The truth is more nuanced. The average investor is generally not driven by greed. As Kahneman puts it: “…the main motivators of money-seeking are not necessarily economic.” He adds: “…money is a proxy for points on a scale of self-regard and achievement. These rewards and punishments, promises and threats, are all in our heads. We carefully keep score of them. They shape our preferences and motivate our actions, like the incentives provided in the social environment. As a result, we refuse to cut losses when doing so would admit failure, we are biased against actions that could lead to regret, and we draw an illusory but sharp distinction between omission and commission, not doing and doing, because the sense of responsibility is greater for one than for the other. The ultimate currency that rewards or punishes is often emotional, a form of mental self-dealing that inevitably creates conflict of interest when the individual acts as an agent on behalf of an organization.” (Kahneman, Thinking, Fast and Slow. 2011) p342. (emphasis added)
Refusing to cut losses when to do so would be an admission of failure is a fear of admitting failure. It is also a fear of regret.
Prematurely taking a gain in a winner comes from fear of the regret that would come if the stock went down.
Fear of failure
I suspect that fear of failure is one of the main reasons many people are unwilling to take risks even if the odds are much in their favor. Some people seem to be more risk tolerant than others. It may be something to do with the mental make-up they were born with. No doubt it also has to do with their life experiences. Children need to learn early on that there is no shame in trying something and failing.
Fear of failure seems to have both an inward side and an outward side. The inward side would be a fear of loss self-esteem. The external side would be fear of loss of face or loss of status amongst friends and colleagues. Someone saddled with a fear of failure might be thought of as risk averse.
Kahneman defines risk aversion and risk seeking behavior in a special way. Risk aversion is an unwillingness to take on a risk in spite of the fact that the likely reward amply justifies the risk taken. Similarly, risk seeking has a specific meaning. Risk seeking is taking on a risk in spite of the likely reward not justifying the risk taken. Risk aversion and risk seeking behaviors are pathological, in the sense that they work against what would be in your best interest.
One bad experience
A novice investor might take a hit early in their investing career and become afraid of common stocks for the rest of their lives. As Kahneman notes, one bad experience can sometimes leads directly to our fear of failure. He explains: “…fear of an impending electric shook was essentially uncorrelated with the probability of receiving the shock. The mere possibility of a shock triggered the full-blown fear response.” (Kahneman, 2011) p326. We have apparently derived from our ancestors a “great facility to learn when to be afraid. Indeed, one experience is often sufficient to establish a long-term aversion and fear.” (Kahneman, 2011) p237. (emphasis added)
An electric shock at some early point in one’s life can create long term aversion and fear; So, with an early investment setback.
Learning how to lose
Novice investors need to learn how to lose. Some investors have a fear of any and all losses. Not all of your stocks are going to be winners. Even if your investment process is grade ‘A’, you are going to have periodic duds. You need to learn how to take those in your stride. If you are well diversified, the duds won’t hurt you over the long haul.
I am a great believer in the benefit of sports in teaching people how to lose. Many young people never learn how to lose. Sports and games are a great place to learn about losing.
Templeton stresses that you won’t always be right. “In order to be flexible in investment management and preserve your freedom to shift around, you can’t expect that every decision you make is going to be right. But the net result over twenty or thirty years is going to be better than if you didn’t try to be flexible.” (Proctor & Phillips, The Templeton Touch, 1983, 2012) p106.
Fear of losing a gain/regret
Selling a stock too soon i.e. over trading violates Buffett’s advice (“Inactivity strikes us as intelligent behavior”). It also comes freighted with a variety of emotions. The mental account Kahneman refers to includes our remembering what we paid for the stock and how much our paper profit is at the moment. Many investors fear that stock market volatility and other unknown dangers will rob them of their gains. This fear is a powerful motivator. The investor has a handsome gain in a stock. The last thing they want is to give that up in a volatile market. They sell and lock in a gain. Their motivation is probably a combination of satisfaction in seeing their astuteness as a stock picker confirmed with tangible proof and relief in avoiding the regret they would have suffered had the stock price gone down and they had suffered a loss.
Fear has made them risk averse. As Kahneman would put it, they sold the stock in spite of the fact that the probable returns from holding the stock would amply have justified continuing to hold it.
It is worth remembering that, at any point in time in the stock market, the price you paid for a stock is utterly irrelevant.
Fear of getting whipsawed/regret
There is a fear of getting whipsawed and a desire to avoid feelings of regret. Investors worry that if they sell the loser the company will immediately bounce back and the stock will soar and that they won’t be able to get back in. If they sell the stock will they regret it? Regret is a powerful force. They may feel that if they continue to hold the stock their potential for regret will be less. In that regard they are right. But, of course, they are continuing to hold a loser when they should sell it.
As Kahneman writes: “people expect to have stronger emotional reactions (including regret) to an outcome that is produced by action than to the same outcome when it is produced by inaction.” He goes on: “The asymmetry in the risk of regret favors conventional and risk averse choices.” (Kahneman, 2011) p348-349.
Fear of future losses
Kahneman describes his concept of Psychological Value as compared with Utility Value. He says Psychological Values of outcomes depend on Reference Points, such as the status quo, or the outcome you expect, or the outcome to which you feel entitled. They also depend on the subjective difference between outcomes such as the feeling that the difference between $900 and $1,000 is much less than the difference between $100 and $200. As well they depend on Loss Aversion. The reactions investors feel to paper losses, let alone real losses, depend on the Pychological Value of the loss as opposed to its pure dollar value. And not only do we weigh losses actually incurred much higher than gain actually won, we also fear future losses much more than we are attracted to comparable future gains. It is probably fair to say that for inexperienced investors paper losses in the stock market have a similar Psychological Value to realized losses.
In a volatile stock market (i.e. all markets) a paper loss should be irrelevant. The only thing that matters is the relationship between current price and current intrinsic value.
Fear of the low probability of a large loss
We tend to be risk seeking where there is a high probability of a small loss and risk averse, i.e. fearful, where there is a low probability of large loss. An example of the latter would be fear of losing where there is, say, a 5% chance of losing $10,000. In this case most people become risk averse. (Kahneman, 2011) p317.
Fear based on vivid memories of recent events
Kahneman uses the vignette of two plane crashes happening by coincidence within a short period of time to illustrate what he calls the Availability Heuristic. People become fearful of plane travel. The truth is that the risks of plane travel haven’t changed and plane travel remains very safe.
Kahneman describes the Availability Heuristic as a short cut we take when we want to estimate the frequency of something. We retrieve instances from our memories. If the retrieval is ‘easy and fluent’ we judge the frequency to be large. Frequency is judged by “the ease with which instances come to mind”. (Kahneman, 2011) p129. The ease of coming to mind is the Availability.
For investors, the lesson is that a stock market drawdown causes investors to become fearful. They are conditioned by what they see in the rear view mirror, which is ugly. They should be looking at the road ahead. Experienced investors love drawdowns because other investors have become fearful. That is just when experienced investors should be greedy. Down markets are less risky than up markets.
Fear of being seen as foolish or different
Shiller reports on experiments by Morton Deutsch and Harold Gerard which examined the question whether crowd behavior could be explained by social pressure within the group or the fear on the part of one member of the group of being seen as foolish or different. The explanation they came up with is that an individual in a group tends to accept the views of the rest of the group because they simply think the others can’t be wrong (Groupthink). Readers will know that I am a great advocate of independent thinking. You don’t want to be part of the crowd, especially when the crowd goes mad.
Fear of missing out
The idea of not swinging at every pitch seems sensible and intuitive. In fact, like so many true insights and deep wisdom, it is quite difficult to internalize this lesson. So many of our best learned ideas come from the school of hard knocks. It sometimes takes a hammer to get things into our brains. Not swinging at every pitch is intuitive on one level and counter-intuitive on another. There is probably some evolutionary psychology basis for it. We have a real fear of missing an opportunity. FOMO is ‘fear of missing out’ – a powerful impeller. The bold side of us tells us to seize the moment. It requires tremendous discipline to wait for the right pitch. There will always be another opportunity – another pitch.
Investing can be a psychological roller coaster ride. There are certainly more fears around investing than I have touched on in this post. I find it fascinating to think about what it is about the great investors like Warren Buffett and John Templeton that makes them great. What sort of personal qualities or traits do they have that allows them to succeed? It is certainly more than a high I.Q.
One good word to describe them is equanimity. What they seem to have is a good handle on all the fears that surround investing. This is something investors can nurture and develop over time.
Other posts on investment psychology
This post is part of a series. Readers are invited to read Investment psychology explainer for Mr. Market – introduction. This will give you a better understanding of some of the terms and ideas and give you links to other posts in the series.
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