Cognitive Biases

The Disposition Effect

I attended a Behavioral Finance course on Omission Bias last week and wanted to share what I may have learned. Sounds exciting, right?

The big picture on Behavioral Finance is to study decision making in the financial arena and how it is influenced by our internal biases and thought patterns.

With respect to investing, the important take-aways are:

  • anticipation of future regret may drive irrational decisions;
  • risk-averse behavior rises when winning while risk-seeking behavior rises when losing, again causing irrational decisions.

The foundation of this module is the Prospect Theory, proposed by psychologists Daniel Kahnemann & Amos Tversky in the 1970s, which provides insights on human behavior that are not reflected in expected utility theory. The key insight is that our happy meter responds asymetrically across gains and losses.

To be complete, the Rational Model, a long held psychic utility model, simply holds that whether you are winning a dollar or losing a dollar, the impact on your happy meter is equal and opposite.

Pictorially, Prospect Theory would notionally appear something like this (from the Duke course material):

If you reflect on this for a bit I think you will agree with its implications. Essentially:

  • losses negatively impact our happy meter more for the same dollar value;
  • in each case, the impact diminishes with scale but much slower for losses.

And this all leads to our inevitably falling into the traps of some other Cognitive Bias.

The Disposition Effect

This is the tendency to be risk averse over gains while being risk seeking over losses.

Consider that equities that are going up tend to continue up until some event causes a change. As such, we should hold winners until there is a clear indication of a change (an inflection point). And yet. Our tendency is to sell winners because, as we all know, "Nobody ever got hurt taking a profit". Unless you consider missing out on more profit as getting hurt. This is the epitome of risk averse behavior exactly when we should hold out for more.

Equally, equities on the downward trend will continue until an event intervenes. We should drop losers with reasonable dispatch (a very subjective measure we cover in our TAP training). However, our tendency is to hold them longer than is reasonable in hopes of a change in our favor. That is the definition of risk seeking behavior, precisely when we should cut and run.

As an example, one of the 'experts' on the internet had his clan buy into Goldman Sachs (GS) right after President Trump was elected. His crewe rode it to a $35k profit. And then rode it to a $10k loss. At which point the stellar expert decried GS as the worst stock ever (meaning not his fault), something he would never again recommend.

Consider the possibility that the expert only got things half right. Riding up is great until there is an inflection point. Then get out. To blindly hold to a significant loss is outrageous. And this guy's crewe pays him $2k a year for this advice. Nice work if you can get it.

Lesson and Actions

The lesson, as usual, is that we have met the enemy and it is us.

Here are some tactics to employ that are aimed at mitigating our internal biases which conspire to diminish our performance.

Tactic 1, winning position:

Use options and roll up at some preset point. This can be at a dollar value profit, a percentage profit, or a Delta target. This tactic has the advantage of moving the origin of the Prospect Theory notional chart to a new spot.

This ensures that you again feel the increased happy of continued gains while also keeping the specter of losses close.

You will also be taking money off the table thereby diminishing the real loss should the position go against you.

Tactic 2, winning position:

Use options and roll to reduce the time to expiration. We generally look at options 6 months or more in the future. There are a variety of reasons for this which we cover in the 10alpha Program (TAP(c)).

It is apparent that less time was required to realize the expected gain in the equity. Never buy more time than you need, so pulling the expiration forward will enable you to take more money off the table while continuing to participate in the equity's gains.

Tactic 3, winning position:

Use options and do a hybrid of tactics 1 and 2 by rolling up and pulling forward.

Tactic 4, losing position:

With a standard operating procedure set at some not-to-exceed loss, if you reach that loss, exit the position.

No questions ... No hoping ... No praying.

You can always get back in at a better price. Our TAP course provides advice and recommendation on how to manage this situation.


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