Most economists work on the assumption that all investors are rational. All of us who have actually invested know that isn’t true. But why?
What is it about human psychology that prevents us from making the right decision when it comes to investing?
I Can’t Sell at THAT Price
I’ve written before about how I’ve lost money because I hesitated to sell my stock.
Why is it that we never seem willing to sell stock we own, even if we have made a profit?
It turns out, it’s because we tend to overvalue the things we own. In Predictably Irrational, Dan Ariely discusses this unique aspect of human behavior.
A study he conducted with college students trying to buy Duke basketball tickets illustrates this phenomenon. Duke students need to enter a lottery and wait in tents for days in order to get tickets. So everyone clearly values a ticket. But the students who received tickets, assigned a greater higher value to them than the students who didn’t.
Students who didn’t get tickets in the lottery were willing to pay around $170 to buy them. But, students who owned tickets weren’t willing to sell for less than $2,400. The students with the tickets wanted 20 times more because they would be losing something (in this case the ticket and opportunity to see the game live).
This was the key finding in Ariely’s study. We try to avoid losses or even the appearance of losses. Sure, selling the ticket would mean the student received money, but it also meant they were losing a ticket. And that thought of losing weighs more on the decision process than the monetary gain.
Avoiding the Ownership Bias
When it comes to investing, we need to remove this ownership bias from our decision making process.
How often have you had an investment that’s made a profit, but you haven’t been able to sell because you think “Maybe it will go higher?”
This is your brain.
This is your brain on drugs.
Now this is your brain fearing a loss.
Ariely describes in his book how this fear clouds our decision making.
So how can we overcome this bias and improve our decision making skills?
Step one: realize this bias exists.
Making Better Decisions
Once we realize that we overvalue what we own, we can work to remove this bias from our decisions.
Next time you have an investment, review it as if you were buying more, not trying to sell it. Looking at an investment from the perspective of a buyer will help remove the ownership bias.
If you think the investment is overvalued and you wouldn’t purchase anymore, then why would you still want to own it? Take the emotion out of the decision (and I know this is easier said than done), but if we are going to be better investors, we need to try.
If you can’t make a reasonable case to buy an investment at the current price, then you know it’s time to sell. While following this and selling for a profit can be easier, it is much more difficult if you’re selling at a loss. Yet, the same rules apply here, too.
More times then I care to admit, I’ve held on to a stock too long because I didn’t want to sell for a loss. Not only was the fact that I lost money preventing me from making a rational decision, but thanks to Predictably Irrational, I know I also overvaluing my ownership.
I knew that the stock price would go back up and I would be able to get back to even.
I knew that the market undervalued my stock and there was no reason it should be so low.
I knew this until it wasn’t true and the bubble I created for myself burst when the price dropped further down.
After I had lost even more money, I finally came to the rationalization that the fundamentals had in fact changed, the economy shifted, or some other factor had rightly impacted the company.
How many times has this happened to you?
If we only had clearer heads when making decisions, situations like this wouldn’t occur as often. That’s why it’s important to realize our psychological shortcomings so that we can plan ahead and avoid them.
I’ve started looking at investments from a buyer’s perspective. This helps me remove my emotional attachment and look closer at the facts surrounding the company.
Another good idea would be to create an investment checklist. Having a checklist can help you take an unbiased view of your investment. If your checklist says it’s overvalued, then it’s time to sell. Just think about the areas you typically review when making an investment decision and incorporate it into a simple rating system.
Overcoming Human Nature
With all this being said, I still realize it’s difficult to overcome our natural instincts. But that doesn’t mean we shouldn’t try.
If we know that we have an ownership bias, why should we let that impact our decisions?
Why should we settle for lower investment returns because we won’t sell an overvalued stock?
We shouldn’t. While we’ll never be completely rational like the economists think we are, that doesn’t mean we have to be completely irrational either. Understanding our blind spots is the first step to overcoming them and improving our decision making abilities.
What’s one time you made an irrational investment decision and what have you done to prevent it from happening again?