50 Ways to Lose Your Money (Without Trying)

Teresa, February 6, 2008 @ 8:30AM ET | Link | RSS | Read via Email | Start a Discussion

Discretionary traders often struggle with “discipline” issues. That’s because humans appear to possess a constellation of character traits that make us poorly adapted for making decisions under risk:

Richard Thaler: The Winner’s Curse (PDF)
In a first price auction there are two factors to consider, and they work in opposite directions. An increase in the number of other bidders implies that to win the auction you must bid more aggressively, but their presence also increases the chance that if you win, you will have overestimated the value of the object for sale-suggesting that you should bid less aggressively. Solving for the optimal bid is not trivial. Thus, it is an empirical question whether bidders in various contexts get it right or are cursed. I will present some evidence, both from experimental and field studies, suggesting that the winner’s curse may be a common phenomenon.
Barber, Odean and Zhu: Systematic Noise
Recent studies examine the trading patterns of individual investors and possible psychological motivations for those patterns. For example, individual investors tend to hold on to losing common stock positions and sell their winners (Shefrin and Statman (1985); Odean (1998); Shapiro & Venezia (2001); Grinblatt and Keloharju (2001); Dhar and Zhu, (2002); Jackson, 2003). They also sell stocks with recent gains (Odean (1999); Grinblatt and Kelharju (2001); Jackson (2003)). While most investors buy stocks that have performed well, investors who already own a stock are more likely to buy additional shares if the price is lower than their original purchase price (Odean (1998)). Investors who previously owned a stock are more likely to buy it again if the price has dropped since they last sold it (Barber, Odean, and Strahilewitz (2003)). Investors tend to buy stocks that catch their attention (Barber and Odean (2002b)). And investors tend to underdiversify in their stock portfolios (Lewellen, Schlarbaum, and Lease (1974), Barber and Odean (2000), Goetzmann and Kumar (2002)) and in their retirement accounts (Benartzi and Thaler (2001), Benartzi, (2001)).
Mullainathan & Thaler: Behavioral Economics
Departures from rationality emerge both in judgments (beliefs) and in choice. The ways in which judgment diverges from rationality is long and extensive (see Kahneman, Slovic and Tversky, 1982). Some illustrative examples include overconfidence, optimism, anchoring, extrapolation, and making judgments of frequency or likelihood based on salience (the availability heuristic) or similarity (the representativeness heuristic).
What Drives the Disposition Effect?
One of the most robust facts about the trading of individual investors is the “disposition effect”: when an individual investor sells a stock in his portfolio, he has a greater propensity to sell a stock that has gone up in value since purchase, than one that has gone down. The effect has been documented in all the major databases of individual investor trading activity and has been linked to important pricing phenomena, including post-earnings announcement drift and momentum in stock returns. Prospect theory, a prominent theory of decision-making under risk proposed by Kahneman and Tversky (1979) and refined in Tversky and Kahneman (1992), posits that people evaluate gambles by thinking about gains and losses, not final wealth levels; and that they process these gains and losses using a value function that is concave for gains and convex for losses. This functional form captures the experimental finding that people, on the one hand, are risk averse over gains – they prefer a certain $100 to a 50:50 bet to win $0 or $200 – but, on the other hand, are risk-seeking over losses: they prefer a 50:50 bet to lose $0 or $200 to a certain loss of $100.
How to Stop Your Emotions From Wrecking Your Returns
Make no mistake: Emotions can hurt your investment results. For instance, a study published in Psychological Science in June 2005 found that people with impaired emotional responses made more-sensible financial decisions. These folks, who had lesions on their brains that limited their emotional reactions, were more willing to take gambles where the potential payoff easily outweighed the potential loss. “When people with normal emotional reactions lost, they got discouraged and stopped gambling,” notes one of the study’s authors, George Loewenstein, an economics professor at Carnegie Mellon University.
Can behavioral economics save us from ourselves?
The other two-thirds of participants’ money was scattered across the 456-fund list, making it difficult to compare the outcomes. So Thaler and Cronqvist calculated the mean aggregate portfolio of Swedes who chose their own funds. Despite initial enthusiastic reports, that portfolio, they found, leaned even more heavily toward stocks than the default fund–96.2 percent, of which 48.2 percent were Swedish stocks. Only 4.1 percent of the funds were indexed, and as a result participants paid higher fees. The fund that attracted the largest market share, aside from the default, was Robur Aktiefond Contura, specializing in Swedish technology and health-care stocks, whose value soared 534.2 percent over the five years preceding the PPM launch. Three years later, however, it had lost 69.5 percent of its value. Overall the mean aggregate portfolio was down 39.6 percent after three years. The default fund, on the other hand, was down significantly less, 29.9 percent–not too terrible given that markets were falling worldwide.
Just How Much Do Individual Investors Lose by Trading? (PDF)
We document that individual investor trading results in systematic and, more importantly, economically large losses. Using a complete trading history of all investors in Taiwan, we document that the aggregate portfolio of individual investors suffers an annual performance penalty of 3.8 percentage points. Individual investor losses are equivalent to 2.2 percent of Taiwan’s GDP or 2.8 percent of total personal income – nearly as much as the total private expenditure on clothing and footwear in Taiwan. Using orders underlying trade, we document that virtually all of individual trading losses can be traced to their aggressive orders; passive orders placed by individuals are profitable at short horizons and suffer modest losses at longer horizons. In contrast, institutions enjoy an annual performance boost of 1.5 percentage points (after commissions and taxes, but before other costs). Both the aggressive and passive trades of institutions are profitable.
Sendhil Mullainathan and Andrei Shleifer: Persuasion in Finance (PDF)
We examine advertisements in Money and Business Week magazines over a decade 1994-2003: before, during and after the internet bubble. Financial advertising is helpful for distinguishing the two models because beliefs about investment change systematically over the course of the bubble. Specifically, we argue that investors hold two broad systems of beliefs about investment: growth and protection. The former sees investing as a way to get rich; the latter as a way to secure the future. As stock prices rose, investors’ beliefs shifted towards growth; as prices declined beliefs shifted towards protection. The behavioral theory predicts that advertisements should respond to these shifts by catering to the changing sentiments. The traditional theory on the other hand makes predictions based on the usefulness of returns information during booms and busts. We test a variety of specific predictions of the behavioral theory and find they are consistent with the data.
Is Money Really ‘Smart’?
We also present evidence that highlights the role of consumer flows in patterns of performance persistence. First, inflows are highest for funds with the best past performance, which temporarily reduces the equity exposure of these funds. This serves to reduce momentum-based and other equity performance benefits provided by the stockholdings of these funds. However, offsetting this effect is that managers of these top funds eventually invest inflows in stocks with high future returns. At least a part of these returns are due to these top managers buying additional stocks with high past returns–thus, large cash inflows allow top-performing funds to augment the return boost provided by passively holding their past winners with another boost provided by actively trading on momentum–this momentum investing mostly happens with winning managers adding new momentum stocks to their portfolios rather than increasing an existing position in a momentum stock.
Vanguard: Market-timing and performance-chasing are losing strategies. (PDF)
The appeal of market-timing–altering a portfolio’s asset allocation in response to short-term market developments–is strong. Successfully buying low and then selling high at precisely the right moments promises exceptional rewards. However, the opportunities that are clear in retrospect are rarely visible in prospect. Empirical evidence has repeatedly shown that the likelihood of success is remote. In fact, aggressive market-timing strategies can have a potentially devastating impact on long-run portfolio performance. Similarly, the tendency for investors to chase performance by buying an investment simply because its price is rising has proved to be a poor long-term strategy. Indeed, asset-allocation decisions based on such so-called momentum strategies have empirically underperformed portfolios that are constructed through careful strategic asset allocation. The following sections explore market-timing and performancechasing, reviewing both the theoretical and empirical weaknesses of these strategies.

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