A couple of installments ago I commented on some of the seemingly irrational reactions that commonly guide investors’ decisions or feelings.
One of the previously mentioned biases was the effect of the losses on the perceived utility. Human beings assign greater weight to losses than to gains of similar proportions.
Another factor of behavioral economics theory that we can bring to the table is that of decreasing utility. Let’s assume that a person earns $1,000 for the first time, if, by making a series of decisions he succeeds in repeating the feat five times, the perceived utility for winning the last batch would be less than the first.
The context has an effect, in this case, the second time he earned $1,000 he managed to double his capital, while the fifth time around, the increase in his net worth would be 25 percent, that is, from $4,000 to $5,000.
However, how a result is reached also has serious implications for the perception of the investor or trader.
The previous example highlights the perception of change (+$1,000) with respect to the previous position. In the second iteration, our subject was a person who started with $1,000 and finished with $2,000, while in the last case he was a person who had $4,000 and ended with $5,000.
But now let’s suppose that two different people, both with an initial capital of $1,000, enter a competition where there will be 5 rounds of coin flipping, and in each toss they can win or lose $1,000.
Participant A gets the following results: Win, Win, Win, Lose, and Lose; while participant B obtains: Lose, Lose, Win, Win, and Win. Although both result in a final balance of $2,000, it is very likely that player B, who was at a time with a loss of $1,000, ends up with a higher perceived profit (happier). While player A, will probably curse after having been at some time with a balance of $4,000 and eventually comes up with just half of it.
In this example, several psychological biases are present such as anchoring, recency, or endowment effect, now let’s see how they compare in the stock market.
In an investment course the professor made a comment that I still have very present. At that time Mexichem shares traded around 50 pesos and the professor said: “If an investor says: ‘I hold shares of Mexichem at 30 pesos (referring to the purchase price)’ he has it all wrong, we all have shares worth 50 pesos today, and with this information further decisions should be made. (Obviously disregarding any taxation implications).
In this case, previous irrelevant information would be influencing the investment decision. If an action in the past was at 30 pesos, but today it is at 50, the decision to maintain or sell it should be independent. Probably increasing our position would be affected if you already have a relevant position, but the question at all times should be: what exposure do I want to have in this action in these prices, based on my expectations?
Now, we have already seen how the road traveled, “from losing to winning” or vice versa, affects perception. We also saw how decisions can be biased if someone is already in the market (Endowment Effect), and finally, the impact of recent history.
Let’s see a practical example. Towards the end of last year (December 12) the S&P index was around 2,660 points, by April 5, 2018, it closed at similar levels 2,665 points.
From a general point of view, just 4 months apart, how much can perception change? Considering that the S&P absolute level was pretty much the same.
Did it changed the opinion of someone who did not want to buy in December and now wants to buy? How did the perception of someone who bought in December and decided to sell during April?
The fact is that perception actually changed, while the macro assumptions (levels of rates, estimates of growth, among others) persisted, it would be worth taking into account the following information.
By December of 2017 the S&P accumulated a return in the year of 19%. Despite the fact that market rallies tend to build up anxiety in the investors, the feeling is rather optimistic. On the other hand, in the levels of 2,665 in April, recent history describes a sudden adjustment of more than 7% against the peaks reached at the end of January. Remember that stock prices tend to fall faster than they rise.
As you can see, the traders willing to buy and sell — the same asset — with similar fundamentals, in this window of time surely have a different strategy and opinions. Those who remained invested and/or bought in December are probably trend followers, while those who decided to buy this time around might be swing traders.