Distorted risk sense
Let’s see if we can come up with a set of what Daniel Kahneman calls ‘risk policies’ to help us control our animal spirits when faced with risky situations.
John Maynard Keynes was really the first behavioral economist. He wrote: “Most, probably, of our decisions to do something positive, the full consequences of which will be drawn out over many days to come, can only be taken as a result of animal spirits – of a spontaneous urge to action rather than inaction, and not as the outcome of a weighted average of quantitative benefits multiplied by quantitative probabilities.” (Keynes, The General Theory of Employment, Interest and Money. 1936, 2007) p.161. (Emphasis added)
We like to think we engage in probabilistic thinking when we invest. The highest we can put it is that we intuit risks. In reality, it is no more than using gut feeling. This sounds like a pretty frail basis to make big decisions involving our financial future. The truth is that, with a bit of book learning and decent real world experience, we can do a pretty good job of intuiting risks.
Good risk sense
For the most part investors who are not total neophytes have good intuitive risk sense. Most understand that stocks produce higher returns than bonds over the long haul but are more risky. They are prepared to invest a portion of their savings in stocks to take advantage of this higher return.
It’s also true that some investors have a higher tolerance for risk than others. And some people are just naturally less inclined to take risks than others. This is not a psychological problem. It’s just human nature.
Distorted risk sense
What I want to look at in this post is something different. It is about investors who normally have good risk sense but make bad decisions because their normal good sense gets warped by animal spirits. They suffer distortions in their risk sense caused by behavioral biases and cognitive errors.
They suffer from what Daniel Kahneman calls the “consistent overweighting of improbable outcomes – a feature of intuitive decision making [that] eventually leads to inferior outcomes.” (Kahneman, Thinking, Fast and Slow. 2011) p.321
Risk aversion and risk seeking behavior
There are many situations in investing in which investors with normal risk sense overweight improbable outcomes and get a bad result. To make all this clear we need to define the terms risk aversion and risk seeking.
Risk aversion does not have the hazy meaning of somehow not liking to take risks. Risk aversion is specifically an unwillingness to take on a risk in spite of the fact that the reward amply justifies the risk taken. Similarly, risk seeking has a specific meaning. Risk seeking is taking on a risk in spite of the reward not justifying the risk taken.
Some examples – Risk averse
> Selling a stock too soon
Many investors fear that stock market volatility and other unknown dangers will rob them of their gains. They forego future likely gains to lock in a small gain in the stock of a good company.
The decision was the result of risk aversion brought on by the chance to cash in a small gain.
>Accepting a lower return to avoid uncertainty
There is a risk premium attached to equities as against risk free United States Treasury bonds. That is, bond investors are willing to accept the lower return from bonds because stocks seem to carry with them a possibility of a large loss even though the probabilities of loss in a balanced and diversified portfolio of good stocks over the long haul are low. Over the long run this is a costly error.
This is an example of where investors become risk averse where there is a low probability of significant loss.
Some examples – risk seeking
> Taking a flyer
The classic case here is taking a flyer on a stock with slim odds. IPOs, meme stocks and concept stocks fit the bill. The vast majority of these companies will never amount to anything. The probabilities are not on your side. But many investors love to think they will hit the jackpot.
It seems humans tend to be risk seeking when there is a low probability of a high gain. If we really thought about the chances of a decent return, we would see the expectation of a good outcome is so low that it’s not worth the effort. You are donating money to promoters.
> Faced with a small hope of avoiding a large loss
When our stock has dropped in price from our purchase price of $20 to $15, the investor is facing Bad Options. They can sell and realize the loss. They can hold and risk the stock going down further thus increasing their paper losses. Both are Bad Options. Initially, in face of bad options, we tend to be risk averse. This is a complex situation because of price anchoring and the endowment effect of our purchase price. With proper reframing an experienced investor might decide to buy more at a better price.
But then the stock goes to $12. As this happens a switch can flip. The investor is facing a really bad options and a really large loss. The investor may well be irrationally inclined to double down. Risk seeking behavior may take hold. As Daniel Kahneman puts it: “The thought of accepting the large sure loss is too painful, and the hope of complete relief too enticing, to make the sensible decision that it is time to cut one’s losses.” (Kahneman, 2011) p.319
The four fold pattern
We have just looked at four examples of ‘consistent overweighting of improbable outcomes’ that investors engage in. We could come up with dozens of other examples both in investing and in other parts of our lives. The four situations are actually examples of what Kahneman calls the fourfold pattern. Two lead to risk aversion and two lead to risk seeking. Two are examples of high probabilities and two are examples of low probabilities.
Kahneman tells us that; “The fourfold pattern of preferences is considered one of the core achievements of prospect theory. (Kahneman, 2011) p.317.
Let’s turn to what we can do about this. Remember, we are trying to counteract our all too human tendency to ‘overweight improbable outcomes’.
In the first post in this series, I explained what Daniel Kahneman calls risk policies. I also explained that I have created risk policies for investors that I call gap-to-edge rules. What follows are some simple rules we can adopt to help us overcome the problems described above.
Gap-to-edge rule: Make a conscious assessment of the risk/reward proposition around any investment decision.
The idea is to think about your expected return. Cashing in a small gain should be weighed against the likely gain from the investment over the longer term. Accepting a lower return because it’s said to be sure thing may mean you are overweighting safety against return. For an investor with a fairly normal level of risk tolerance these decisions are a mistake. But the error can be overcome with a thoughtful risk/reward/expectations assessment.
Gap-to-edge rule: Be wary of your gut or instinctive feelings.
Your gut needs training. Many of your instinctive feelings are the exact opposite of what you should be doing. Sometimes buying is counterintuitive. An example would be when prices have gone into the tank. That is actually a good time to buy.
I am a great believer in learned instincts. They may come from reading about investing. Very often they come from the school of hard knocks. They may save your bacon.
Some of the best gut instincts will save you when the investment doesn’t pass the smell test or doesn’t send out good vibes.
Gap-to-edge rule: Never sell a winning stock unless doing so improves the overall quality of your portfolio.
Selling winners and holding onto losers was called by Peter Lynch cutting the flowers and watering the weeds. Selling winners can reduce the quality of your portfolio. Selling losers can increase its quality.
Gap-to-edge rule: When a stock is showing a price loss, focus on the fundamentals.
“The trick is not to learn to trust your gut feelings, but rather to discipline yourself to ignore them. Stand by your stocks as long as the fundamental story of the company hasn’t changed.” (Lynch, 1989, 1990)p.71. This is slightly different from what I have written above.
The right response in a situation of paper losses is to change the Reference Point to intrinsic value. It may also be time to carry out a Broad Framing analysis of the situation.
As I noted at the beginning of this post. We have to rely on animal spirits and learned intuitions when making investment decisions. It is impossible to make ‘calculations’ of risk when investing is inherently uncertain.
Gap-to-edge rule: Ignore what you paid when deciding whether to buy more, hold or sell a stock.
What you paid for a stock is utterly irrelevant. As noted above, change the Reference Point. Focus on intrinsic value.
Gap-to-edge rule: In making any investment decision, make a clear distinction between price and intrinsic value.
Use intrinsic value as a Reference Point to mitigate a variety of behavioral biases and cognitive errors.
Warren Buffett’s words in the 2008 Berkshire Hathaway annual report could not be clearer: “Price is what you pay. Value is what you get.”
Gap-to-edge rule: Avoid IPOs, meme stocks, high flyers and concept stocks like the plague
Gap-to-edge rule: Remember that when things seem too good to be true, they usually are
Gap-to-edge rule: Keep it simple.
There is lot to be said for investing in really high quality companies. A high quality company is not a cash cow. It is a company that makes lots of money and has opportunities to reinvest profitably in the business
Gap-to-edge rule: Sleep on any decisions you make to buy or sell shares.
Never make any investment decision impulsively. Pause to think things through.
Gap-to-edge rule: Learn something from every mistake.
Treat each and every mistake as a learning experience.
This post has been about circumstances that can cause investors to become risk averse and risk seeking. Both of these are pathological. The ultimate defense is to develop risk sense. It’s a bit like common sense. This comes from learning about the kinds of situations that can cause us to make stupid decisions. Some we only learn from making mistakes.
For readers wishing to dig deeper into this topic take a look at the Motherlode Chapter 13. Overweighting Improbable Outcomes
This chapter contains these sections:
13.05 Hitting the low percentage shot
13.08 Particular risks with ‘easy money’
13.10 Stressful events and risk aversion
13.11 The Monday morning quarterback is us
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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