Behaviorial Finance: Coping with gains

In a previous post on my series on Behaviorial Finance, I reviewed Richard Thaler’s concept of Loss Aversion behaviour which states that people, will feel more hurt emotionally with a loss than an equivalent gain gives pleasure. Consequently, we will be more prone to take excessive risks to eliminate the loss.

Thaler also observed this phenomena in reverse specifically in how people behave when they are making successful financial/investment decisions. Thaler cites that this behavior gains critical mass in periods that would be described as financial bubbles, where people are enjoying repetitive excessive gains in their investments. Using the stock market euphoria of the late 90’s as an example, Thaler comments,

“…in the 1990’s individual investors were steadily increasing the proportion of their retirement fund contributions towards stocks than bonds, meaning that the portion of their new investments that was allocated to stocks was rising. Part of reasoning seems to be that they had made so much money in recent years that even if the market fell, they would only lose those newer gains. Of course the fact that some of your money has been made recently should not diminish the sense of loss if that money goes up in smoke. The same thinking that pervaded the views of speculative investors in the boom housing market years later. People who had been flipping properties in Miami, Vegas had a psychological cushion of house money that lured them into thinking that at worst they would be back to where they started. Of course when the market turned down suddenly, those investors who were highly leveraged lost much more than house money. They lost their homes…”

Conventional thinking has been (and I’ve practiced this myself) that when you have gains in a stock you should take some money off the table and sell the equivalent amount you initially invested in and the then hold the profit amount. At that point, you are essentially playing with the house’s or in this case the stock market’s money. If we were to lose all that “profit” or house money, we wouldn’t feel we really haven’t lost any money. However according toThaler’s observations about Loss Aversion, we will likely take more aggressive, and riskier decisions when the House Money is reduced, which perpetuates the bubble factor. We will either double down on the investment, continue to hold because we feel it is still a high quality investment compared to other investments (Endowment Effect) or engage in other high risk investment opportunities to regain that House Money. During bubble or bull markets periods, it will work for awhile, however at some point that excessive risk will bite back and ultimately that House Money will likely be gone along with part or all of the initial investment they originally put down.

I had a faced a situation that demonstrates this house money behaviour. I had owned a position in NeuLion and it was a very good investment decision as it was up nearly 90 percent so I had made a lot of money on paper. Unfortunately, the stock crashed but I was still up 25%. I decided to sell enough stock to cover my initial investment. The stock I had left was House Money. At the time I decided to do this because in my mind I could rationalize and live with the fact that I didn’t really lose money even though the stock tanked royally. The question that I faced was should I buy more stock at the lower price if fundamentals of company were still strong or sell the remainder of my position if it fell below my loss threshold which is 20 percent. Under the Loss Aversion behaviour that Thaler described, I would buy more stock even if the company has experienced a negative game changer moment and is a riskier prospect. With awareness of these types of behaviours, I decided to not buy additional stock and instead decided to ride the position out to see if the company could turn it around. If it couldn’t and the position fell another 20 percent, I would sell the remainder of the position. It’s interesting as normally one of my disciplines I have built up is to sell positions when it crosses a minimum return threshold that I am seeking. Normally for me that is in the 20 percent range but this time, I decided to hold onto the stock for longer, more so for practice as in the past I have realized that I tend to sell shares earlier and in many cases left money on the table. In this example I strayed away from my discipline and while I didn’t lose money, it could have easily gone the other way.

Greed ultimately drives this level of behaviour. The theme from this observation is that as much as it is important to manage your losses, it is equally important that you manage your gains, or more plainly, manage your greed. When you make investment decisions, you need to establish a minimum return you are seeking and when you reach that threshold you should re-evaluate the investment to determine if there is still upside or if it makes sense to bank the profit and move on to better opportunities. Greed gets the better of us in most cases, but again developing a discipline and avoiding the false sense of security that the House Money Effect offers can allow you a greater chance to maximize the profits and benefits of your successful investment decisions.