Part of being an astute investor involves hours of analyzing the capital markets, actively researching the companies and strategies you invest in, and staying up to speed on current events. That’s plenty of work on its own.
But there is another aspect to smart investing that generally receives less attention but is arguably equally important. It involves studying ourselves – our behaviors and tendencies as investors, how and why we make investment decisions, and how those decisions may impact our returns over time.
Most of this research falls within the field of Behavioral Finance, which challenges the assumption that “individuals act rationally and consider all available information in the decision-making process.”1 Investors rarely do those things, and that’s why studying behavioral finance can be so beneficial. The general thinking is that the more we understand the decision-making process, the better equipped we can be to help investors avoid common mistakes while simultaneously establishing guidelines for a disciplined investment process.
This post, in particular, focuses on the “disposition effect,” which may lead investors to trade too often and at the wrong times.
Understanding the Disposition Effect – Does it Apply to You?
The ‘disposition effect’ revolves around the idea that investors have an emotional bias to loss aversion. In other words, investors don’t like losses – at all – and it may affect the way we trade. One of the foremost researchers on this topic, Terrance Odean of the Haas Business School, has published findings identifying that “investors with US discount brokerage accounts sold winners more readily than losers, a behavior consistent with the emotional bias of loss aversion and the cognitive bias of believing that their winners and losers will revert to the mean.”1
In layman’s terms, Odean’s research suggests that investors tend to irrationally sell winners because they think those stocks will eventually decline (mean revert) again, while at the same time investors managed to hold onto losers for too long because they (again irrationally) believed those stocks would rise again. Since both lines of thinking are emotionally-based, it’s arguable that neither is very beneficial.
In the realm of trading, researchers found that the disposition effect can potentially hurt returns. A study conducted by Odean and Barber (1999) found that investors with brokerage accounts trade too much—damaging returns—and tend to sell winners and hold onto losers (the disposition effect). One of the conclusions is that the disposition effect not only caused investors to trade too much but also at the wrong times. The researchers found that “stocks sold do better than stocks bought by about 3.5% over the following 12 months. The frequent traders not only had higher transaction costs because of excessive trading but also experienced opportunity losses because of the disposition effect.”1
If the disposition effect leads to over-trading at the wrong times, it follows that investors should be mindful of it in the decision-making process. Hard data from studies (Odean, Barber 2000) showed explicitly that individual investors who actively trade could be adversely impacted. Of 66,465 households they studied from 1991 to 1996, they found that the most active traders earned an annual return of 11.4%, while the market returned 17.9%. The average household also turned over 75% of its portfolio annually, which is very high by any measure.
Do any of these behavioral patterns apply to you?
Talk to Wealth Manager About Your Trading Approach – And Whether It’s Working
In the words of famed investor Benjamin Graham, “the investors chief problem—and even his worst enemy—is likely to be himself.” What investors want to avoid over the long-term, in essence, is falling into the category below as defined by J.P. Morgan research:
One of the ways to prevent common mistakes that may lead to sub-optimal returns is to acknowledge our decision-making behaviors—the good ones and the bad ones—and try to minimize decisions that may hurt returns. Working with a financial advisor can help. The Wealth Managers at WrapManager can serve as a sounding board to your investment decisions while guiding what we think is the right approach given your long-term investment objectives and goals. Start today by calling us at 1-800-541-7774 or getting a conversation going over email, wealth@wrapmanager.com.
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