So far in "The Little Book of Behavioral Investing: How Not to Be Your Own Worst Enemy", author James Montier has helped investors deal mainly with buy-side issues. Now, in chapter 15, he has explored what’s going in our minds when we are selling or preparing to sell.
Loss aversion?
At the beginning of the chapter, Montier offered to toss a fair coin and if you get it wrong, then you pay him $100. How much would he need to promise you (if you were to win the toss) to get you to play the game with him?
He put this question to 600 fund managers and, on average, they wanted slightly more than $200 to make the bet. Montier called this a typical result for this question, adding that people particularly dislike losses of between two and two-and-a-half times as much as they enjoy similar gains. Answers to the question varied from $50 to more than $1,000. He called this overall effect “loss aversion.”
Interestingly, research has also found a correlation between the degree of loss aversion and performance on cognitive reflection tasks (CRT). Those who correctly answered one question wanted $300; those who correctly answered two questions wanted $250; and those who correctly answered all three questions wanted $165.
Loss aversion meets myopia
As is often the case with "The Little Book of Behavioral Investing: How Not to Be Your Own Worst Enemy," bad turns to worse.
Loss aversion may be an inherent human trait and, if we also suffer from “myopia,” conditions get worse. For example, research has found that the more investors check their portfolios, the more likely they are to suffer a loss. That’s because of the natural volatility of stock prices and our inclination to respond to those fluctuations. On the other side, researchers also found investors are willing to invest more when they see their portfolio less often.
Now, imagine you are a portfolio manager and watching your holdings in real time; Montier wrote:
“It never ceases to amaze me that some fund managers actually have access to their portfolio’s performance in real time; they can see exactly how much they are winning or losing second by second. I can’t imagine many more destructive practices that this. If I’ve done my homework, and selected stocks that I think represent good value over the long term, why on earth would I want to sit and watch their performance day by day, let alone second by second.”
The disposition effect
Montier would like readers to make a distinction between behavior after a loss and behavior when there is a risk of losing. He asked us to give thought to the following four choices:
A: Certain gain of $24,000.
B: 25% odds on winning $100,000 and a 75% chance of no gain at all.
C: Certain loss of $75,000.
D: 75% odds on losing $100,000 and a 25% chance of no loss at all.
Montier reported that most people consistently choose A and D, a combination that made no sense to him. Here is his interpretation of the results:
- Choosing A over B is consistent with risk aversion.
- Choosing D over C is risk seeking: it means a certain loss and a chance of losing $100,000 rather than $75,000.
From this, he proposes that “in some bizarre mental world” there is a belief that a loss is not a loss until it is realized. In turn, that may explain why investors hold their losers and sell their winners: The “disposition effect.”
He also cited the work of a researcher who analyzed portfolios at discount brokerages and discovered that investors kept their losing stocks a median of 124 days, while holding their winning stocks a median of 102 days. Further, investors sold 15% of their winners but only 9% of their losers; mathematically, that means they were 1.7 times more likely to sell a winner than a loser.
Stop losses
As an antidote to the disposition effect, Montier discussed stop losses. To illustrate, he compared responses to good and bad earnings reports. When a company has a good report, the stock price goes up and investors begin selling into this price increase. They’re getting rid of their winners. When it is a bad report, prices go down but investors now tend to hang on, hoping the stock will rebound.
Montier said:
“Stop losses can act as triggers to prevent you sliding down the slippery slope of the disposition effect.”
Endowment effect
He also introduced readers to the “endowment effect,” which means “once you own something you start to place a higher value on it than others would.” From an investment perspective, this means that if you already own shares of a company, you may attribute higher value to those shares because you already own some. In turn, that means investors may be reluctant to sell shares because their ownership leads them to believe the stock is worth more than it really is.
To help us understand the endowment effect, Montier quoted Christopher Browne of Tweedy Browne (Trades, Portfolio), who said:
“Make a clear distinction when selling between 'compounders' and cigar-butt stocks. Once the cigar butts come back, you know to get out because they’re just going to go down again. With something like Johnson & Johnson, though, you make a judgment call when it hits intrinsic value, based on your confidence in its ability to compound returns and what your alternatives are.”
“Cigar butts” refers to Benjamin Graham’s penchant for buying stocks that were poor-quality and extremely depressed, but might go up before they went down again. In Graham’s time, it was easy to find real cigar butts that had been partially smoked and thrown away, but could provide a few good puffs before the second smoker finished with them.
Warren Buffett (Trades, Portfolio), a protégé of Graham, started with cigar-butt stocks but eventually moved to higher-quality stocks, compounders that allowed him to keep profiting from the same stock year after year.
Conclusion
In chapter 15 of "The Little Book of Behavioral Investing: How Not to Be Your Own Worst Enemy," Montier took us through some of the psychological effects going on in our minds when we are considering selling.
That started with a discussion of loss aversion, as well as a correlation between performance on cognitive reflection tasks and loss aversion. The greater the skill with the tasks, the lower the degree of loss aversion.
Then there is “myopia,” which when combined with loss aversion, reduces our performance. The more often we check our holdings, the less likely we are to overperform.
Montier suggested stop losses may be a useful tool in overcoming the disposition effect, which refers to the inclination to hold losers and sell winners.
Finally, he pointed out there is an “endowment effect”; it leads us to value things more highly when we already own them. To deal with this, Montier suggested following guru Browne, who recommended distinguishing between cigar-butt stocks and compounders.
About Montier
The author is a member of the asset allocation team at GMO, the firm founded by Jeremy Grantham (Trades, Portfolio) in 1977. According to his Amazon profile, he was previously co-jead of Global Strategy at Société Générale. The author of three books, he is also a visiting fellow at the University of Durham and a fellow of the Royal Society of Arts. The book we are discussing was published in 2010.
(This article is one in a series of chapter-by-chapter reviews. To read more, and reviews of other important investing books, go to this page.)
