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Is Your Financial Planning Strategy Based on Logic or Emotion?

By Edited Nov 13, 2013 0 0

Having a concrete guideline of your fiscal goals, and roadmap to achieve them helps eliminate some of the human irrationality in investing.

When it comes to investing, don’t follow your heart. Instead, follow logic.

Professor Terrance Odean, a Professor of Finance at the Haas School of Business at the University of California in Berkeley, has conducted research into how psychologically motivated decisions affect the way investors make decisions and how they affect prices. To find out more about investment psychology and how it affects our financial management strategies, read the transcript below of an interview between Professor and Odean and Douglas Goldstein on the Goldstein on Gelt show. To watch a video of the interview, scroll further down the page.


Douglas Goldstein:     So tell me, what’s your new study all about?


Terrance Odean:          This is a study done with two colleagues - Brad Barber at UC Davis and Michal Strahilevitz who is at Golden Gate University and is an Israeli who llived in Israel for many, many years. The title of the paper is Once burned, Twice Shy: How Naïve Learning, Counterfactuals, and Regret Affect the Repurchase of Stocks Previously Sold. What we’re interested in here is the psychology of investing, mostly focusing on individual investors, what makes them buy the stocks they buy. In our study, we’re trying to figure out what makes them sell the stocks they sell. What I think is one of the insights of this paper and the work that my colleagues and I have been doing is that when investors buy stocks, usually this is a forward looking process. People are buying because of what they think is going to or they hope is going to happen in the future, but most sellers are backward looking. People like to sell for a game because it makes them feel good. They feel bad if they sell for a loss so they hold on to their losers. The exception of the buying side is if someone has owned a stock recently like in the last year or two. Then, what happened when they owned it the first time and what has happened since they sold it are what determine whether they buy it again. In short, people like to buy stocks they’ve owned before if they made money on it the first time, and if they can buy it at a lower price then they sold it.


Douglas Goldstein:     That’s interesting. I’ve spoken to people and clients coming to my office during my day job when I’m a financial advisor. Sometimes they’ll say, “Doug, I watched the stock. It trades between about 40 and 50. What I plan to do, my strategy, is I’m going to buy it when it’s trading around 40 and I’ll sell it when it hits about 50,” and then all these wait. I see this over and over again. Is that would people to expect to happen?


Terrance Odean:  Yes. First of all, we know that people tend to expect the recent past to repeat itself. That’s why in general, if you see people buying a stock they had owned before, there’s the overwhelming tendency to buy stocks with strong recent returns. People like to buy things that have been going up because they believe that they are going to continue to go up. So this idea of buying something that’s going down is exceptional and it tends to run in the way you just described. People have been following the stock, they may have had experience with it, and they think, “Oh, it’s going to go through this down-up cycle.” We think that investors also tend to match their trading. They can’t do what you’d really like to do, which is buy stock before it goes up and sell it before it goes down. You can’t choose to hold onto stocks that go down and wait until they’ve gone up until you sell them, and you can choose only to repurchase stocks that you’re able to sell at a higher price and buy back at the lower price. People match the trading behavior that would make them a profit when they can, but actually it’s not profitable. For example, we take a look and see that the stocks that people sell for profit and repurchase at a lower price after they repurchased them underperform the market. So the behavior that we’re documenting is not improving their performance.


Douglas Goldstein:     So just to clarify. When someone buys a stock and makes money on it and sells, it actually realizes the gain and then he keeps an eye on this company. When he sees it drop, he’s inclined to buy it back thinking when it drops below his previous sale price then he buys back in?


Terrance Odean:          Yes. That’s the pattern that we document. What we think is driving this is to a large extent that people are trying to avoid the feeling of regret. So if you sell a stock for a loss, chances are you don’t really want to spend much time thinking about that. You feel bad that you sold for a loss. You regret that you bought it in the first place. When you sell for a loss, it’s sort of permanent that the investment didn’t work out. So you’re not likely to think about it. You’re not likely to buy it again to put it back in your portfolio where it reminds you that you screwed up the last time. You are more likely to buy a stock that you sold for a profit and you’re not likely to buy it at a higher price because if you buy it at a higher price than you sold it, you’re going to regret that you sold it. So if I buy something at $80, sell it at $120 and then buy it back again at $140, I’m thinking to myself, “Well, why did I sell it $120. I wished I’d never done that.” But if you can sell it at $120 and buy it back again at $80 or $100 then you get to regret it. You could say, “I sold for profit and I was really smart. I got on it the right time. I got back in it at the right time.” So we think that largely investors are trying to enhance their emotional experience, just to an extent at the cost of their financial gain.

Douglas Goldstein:     We’re talking to Professor Terrance Odean, who is at the University of California in Berkeley. He is a specialist who speaks very widely about how people make decisions about their investments based on all sorts of emotional reasons, very few of them perhaps rational. So based on what you’re telling me now, do people ever make rational decisions on their investments?


Terrance Odean:          Yes, people do make rational decisions. There are lot of people who are very rationally choosing to save for retirement and put their money in well-diversified and low-cost mutual funds and hold it there for a long time, and that all looks pretty rational. But there are also investors who turn their own accounts or run up their transactions cost, buy and sell largely because of their emotional response to what’s going on rather than sort of a clear considered plan. So we have a world with bull types of investors. I focused a lot of my research on the ones who are trading more actively. It’s hard for me to establish that people are making decisions based on psychological issues when I don’t see them doing much. I hope that some of this research helps the investors who are not behaving and not optimally on it to learn to trade better and invest better.


Douglas Goldstein:     One of the things you mentioned before was that the study that you’re involved in now has to do with regret - that people are trying to control whether they will regret the decision that they made previously. Other research you’ve done is more on fear. Does one of these emotions have more of an influence than the other?


Terrance Odean:          I haven’t actually explicitly studied fear. I’m working on a project right now that’s experimental economics, where we’re trying to sort of see what happens when you induce the feeling of fear. We have people watching 5 minutes from a horror movie and then trading in an experimental market. We find actually that there is less irrational difference under those circumstances. We don’t get bubbles on those markets as much as if we showed them an exciting video. The lowest instance of bubbles seems to be when you show them a very boring video, which gets them in a subdued mood. I think that fear enters when everything’s been running pretty smoothly and then suddenly it looks like the world is changing and people remember that they can lose money. A couple of years ago, when the market started to dive and it wasn’t clear how far it could go down, there was a lot of fear. My friends who are financial advisors said that they were spending their days trying to keep their clients from panicking and pulling everything out the market. This was a big problem. One of my good friends, only had two clients who overruled her and said, “Take everything out and put it all in” the equivalent of money market funds. She said, “That meant that they wouldn’t be able to retire when they had thought they would.”


Douglas Goldstein:     You mean that they locked in on their losses at that time.


Terrance Odean:          Exactly. They locked in their losses, and she said they were downing30% to 40% because they had a mix of stocks and bonds. She said, “They’ve just given up on the possibility of recovering that. If the market comes back, this is going to mean that they’re going to have to work for another 5 to 10 years.” Those particular clients sold within 2 weeks of the battle. In general, I understand it’s extremely difficult when the market is tanking and you don’t know how far it could go to just sit there.


Douglas Goldstein:     And you feel like you should do something. My experience was similar also with clients around that time. We were also talking to people about still looking at the long term. I think I only had one client who said, “Doug, it’s all well and good in that long-term stuff but I think the world is coming to an end, sell.” It was only one guy and everyone else understood. They were unhappy because no one likes watching the market go down but they understood what was going on.


Terrance Odean:          So I think what people need to do, and you don’t need to be a client to do this, is think the scenarios to an advance and decide what you’re going to do rather than make the decision when you’re feeling fear and panic. You might have a rule that might involve selling at some point, but what you really don’t want to do is panic when the market dives and you sell everything. Some other people stay out and then they get back in after the market recovers, and while it’s very difficult to predict what the market is going to do, it’s fairly easy to stay if you have a strategy of selling after big drops and buying after big gains.


Douglas Goldstein:     The buy high-sell low approach to investment.


Terrance Odean:          It’s not going to work out that well.


Douglas Goldstein:     Yes, we discovered that also.


Terrance Odean:          That’s a very common emotional response though, because if the market has gone down, they think it’s going down and if it’s going up, they think it’s going up. In fact, the language describes the market that way. People say to me, “The market is going up,” and my response usually is one of the lines of, “What you mean is it has recently has gone up. Neither you nor I know what it’s about to do.” They think real estate is going up, real estate is going down, thus the language itself projects the recent past into the future.


Douglas Goldstein:     Yes, that’s exactly what happens. Terry, we’re just about out of time, but the research you’re doing is fascinating. Tell me in the last minute, just how people can follow what you’re doing and especially some of the new information that you’re uncovering.


Terrance Odean:          You mean to see what’s going on with our research?


Douglas Goldstein:     Yes.


Terrance Odean:          My postings are on my website www.odean.org and the new research gets posted on the website. If you want to look at research in finance and generally what’s going on, there is a website www.ssrn.com. Most research is post there and our recent working papers on that website and then of course Scottward Google where you can find almost anything. I and most of the academic researchers try to keep our most recent stuff posted so that our colleagues and your listeners can read about it.


Douglas Goldstein:     Great. We’ve been talking to Professor Terrance Odean from the University of California, Berkeley. You can check out the research that he’s doing at www.odean.org. Terry, I want to thank you again for being on the show and I hope we’ll have you back on again soon.


Terrance Odean:          I look forward to it. Thanks a lot, Doug.


Douglas Goldstein:     Thanks.



Disclaimer: This article is for educational purposes and is not a substitute for investment advice that takes into account each individual’s special position and needs. Past performance is no guarantee of future returns.



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