What lies within the investor's psyche
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Having examined how emotions are linked to chart patterns, technical analyst Lesley Beath peels back the layers of individual investor behaviour.
In the previous article, we spoke about emotions as they are reflected in trends and chart patterns.
But as I noted at the time, "there are other emotions that come into play. They are not linked to typical chart patterns, but to the behaviour of the individual and how they make their investment decisions".
We have spoken about the emotions of fear, greed and indecision and how those are linked to chart patterns.
The other emotions that we will talk about have to do with the investor's psyche--what lies within us, as opposed to what is affecting the general marketplace.
Let's look at a study published in the Journal of Marketing Research titled "Once Burned, Twice Shy: How Pride and Regret Affect the Repurchase of Stocks Previously Sold".
The paper was prepared by Terrance Odean (Haas School of Business, University of California, Berkeley), Michal Strahilevitz (University of Arizona) and Brad M. Barber (Graduate School of Management, University of California).
Barber and his colleagues analysed trading records for 66,465 US households with accounts at a large discount broker between January 1991 and November 1996, and another 596,314 US investors with accounts at a large retail broker between January 1997 and June 1999.
The analysis suggested investors often make decisions based on emotions such as regret, disappointment, pride and contentment.
Behaviours were consistent with what the researchers term "counterfactual thinking"--looking back at what could have been--and suggest that investors are motivated by a desire to avoid regret and instead feel pride.
Here are some of the findings of the study. Investors prefer to:
1) Repurchase stocks they previously sold for a gain rather than stocks they previously sold for a loss,
2) Repurchase stocks that have lost value subsequent to a prior sale, rather than stocks that have gained value subsequent to a prior sale, and
3) Purchase additional shares of stocks that have lost value since being purchased, rather than additional shares of stocks that have gained value since being purchased.
Number 1 is easily understood, and to a lesser extent number 3, so let's think about point 2 for a moment.
"An investor who considers buying a stock for a higher price than he previously sold it at, anticipates regretting the sale more poignantly than if he simply avoids thinking about the stock's performance after he sold it or tells himself he has no interest in a longer-term investment in this stock," the paper says.
"If he repurchases at a higher price than he sold, no matter what happens going forward, he will know that he could have achieved a better outcome had he never sold."
There are obviously other emotions that affect the way individuals invest. And in certain situations there will be numerous ones that come together to influence our behaviour.
Let's think about an example here.
Most of you will be aware of the exceptional performance of Bellamy's (ASX: BAL) in 2015. The stock made its debut on the ASX in August 2014 and investors who participated in the IPO had pocketed a profit from day one.
The stock, which was priced at $1.00 in the IPO, posted a low of $1.20 in August 2014 and then climbed to $16.50 by the end of December 2015. That was a 1,275 per cent gain.
The stock had climbed steadily throughout 2015 with the 40DMA giving support as corrections unfolded. The 40DMA was breached in February 2016 and that suggested the trend was changing.
But by the time the 40DMA was broken, the stock had already declined by 22 per cent.
Can you imagine what would be going through your head if you held the stock?
Something like this I would imagine: "This is still a great stock, it's down 20 per cent, and if I sell it now, it's bound to rebound as soon as I do so."
So you wait and a few days later it is down by 38 per cent. Then it rebounds, and you think, "Ah, I knew it was a good stock, its headed higher again".
And it does, for a week or two. Then it starts to decline again. "I should have sold it on the rebound," you say to yourself, as you watch your profits fall even further.
You think about the 200DMA, thinking that might stem the decline, but you don't want to erode your profits any further.
You finally throw in the towel. You watch as the price drifts toward the 200DMA and then you watch it bounce.
Maybe you will re-enter, but the stock is up 6 per cent the next day, 7 per cent the day after and another 5 per cent the next day.
It's back above where you sold out! How can you buy it now? And what if this is just another short-term bounce?
What if you bought now and then it dropped? You would take away from your previous gains.
So you ignore it, telling yourself that you pocketed a good profit. At this stage, you are not focussing on any fundamentals or even the technicals, you are just focussing on your emotions.
The price continues to push higher so you no longer look at it--you don't want to be reminded of what could have been.
In the book The Winning Edge by Jake Bernstein and Adrienne Laris Toghraie, Bernstein talks about emotions versus markets. Below is an excerpt.
"The history of humankind is the history of speculation. In one form or another speculation dates back thousands of years, to the earliest days of recorded history."
"Our forebears speculated daily on the weather, on their search for safe and solid shelter, and on growing crops.
"Whether for the purpose of survival or in business, risk-taking has always been a vital and necessary part of life.
"With risk and speculation, however, come the inevitable and unavoidable consequences and evils of emotion.
"We seek to protect what we have gained for fear it will be lost or that its quantity may be diminished, so we act to preserve it.
"We are motivated by greed to expect large profits from small investments, and so we ignore our rational thoughts and act on emotions.
"There are literally thousands of human behaviours which are motivated by the expectation of financial gain or by the fear of financial loss.
"If we can identify where human emotion is taking the rest of the trading community without becoming influenced by it, we will know that the markets will soon be moving in the opposite direction and profit by that knowledge.
"This distance from the emotions of others, however, requires us to be able to distance ourselves from our own emotions.
"Emotion can be your worst enemy or it can be your best friend. Make it your friend, for it is a formidable enemy that cannot be defeated."
To the extent that any content below constitutes advice, it is general advice (or, in New Zealand, a "class service") that has been prepared by Lesley Beath as a Morningstar authorized representative (ARN 469614) without taking into account your particular investment objectives, financial situation or needs. If necessary, you should consider the advice in light of these matters, consult with a licensed financial advisor, and consider the relevant Product Disclosure Statement (Australian products) or Investment Statement (New Zealand products) before making any decision to invest. Opinions expressed herein are subject to change without notice and may differ or be contrary to the opinions or recommendations of Morningstar as a result of using different assumptions and criteria.
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