CHAPTER 15
Loss Aversion
Learning to Cut Losers Short
“You can’t be afraid to take a loss. The people who are successful in this business are the people who are willing to lose money.”
“I’m not better than the next trader, just quicker at admitting my mistakes and moving on to the next opportunity.”—George Soros
Some investors “fall in love” with a stock or a position. Maybe they love the stock because it has had a high return thus far, or they love the idea behind the company, or they work for the company and enjoy owning shares. In any case, when investors become attached to or overidentified with a stock, they lose the ability to think rationally when the time comes to sell. Like letting go of a favorite old car, or cleaning the “junk” out of the basement, selling a stock can feel painful and unnecessary, even though one wouldn’t purchase so many shares de novo, given the chance. People’s propensity to become emotionally attached to items they own, such as stocks, is called the endowment effect. The endowment effect is an easily measurable result of loss aversion.
Because investors have difficulty selling stocks that they already own, especially if they are losing, researchers surveyed stock investors about how much time they spend on buy versus sell decisions. Ninety percent of active individual investors reported spending more time on buy decisions than sell decisions. However, less than 20 percent said that buy decisions were more difficult. Investors are spending less time making sell decisions, but more than 80 percent report that those decisions are more difficult.
2 What is so difficult about the sell decision? While buy decisions are typically based on a consideration of objective information, sell decisions are often emotionally weighted.
Recall that the endowment effect refers to the phenomenon where people overvalue items they own. In a classic demonstration of the endowment effect, I randomly gave pens to one-half of “behavioral finance” seminar participants. I asked the new pen owners to write down something they liked about the pens. The other half of the audience—the nonowners—were asked to write down objective qualities of the pens. As an aside, please note that researchers have found that when subjects write down admired qualities of an owned item the endowment effect is enhanced, while documenting objective qualities reduces the endowment effect.
The new owners then set a price at which they would sell their pens to the nonowners. The nonowners set a price at which they would buy the pen. The average bid from the nonowners was $1.50 while the average asking price from the owners was $5.50. The people who owned the pen valued it far more than the non-owners. The pen had actually cost $1.50. In general, investors value items they own more than nonowners do, and as a result, they are reluctant to part with them for what appears to be an excessively low price.
An interesting example of the endowment effect was noticed in online auctions. Researchers proposed that the highest bidders in an online eBay-style auction, realizing that they are the highest bidders, might start thinking more concretely about possessing the desired item. As a result, they could become partially attached to it—producing a bias they term a
quasi-endowment effect. The researchers found what they had expected. Online auction participants whose bid is highest at some point during an auction more aggressively pursue the item if their high bid is bested by another’s.
3 A similar effect may happen in stocks as investors “chase” the price higher after missing a fill on a limit order.
As seen in Professor Jennifer Lerner’s studies in Chapter 6, one’s emotional state modifies the strength of the endowment effect. For example, sadness prompts people to think about changing their circumstances. As a result, the endowment effect is eliminated in sad people, since they are now focusing on shifting their circumstances (selling what they own and buying items they do not).
4It’s not only emotional states that alter the strength of the endowment effect. The intention to spend money on a purchase or, in the case of investors, to sell a stock in one’s portfolio appears to reduce the endowment effect. Making up one’s mind to let go of a stock discharges the mental constructs that supported ownership. When it comes time to sell, there are no emotional connections spurring second thoughts.
It doesn’t make sense that the endowment effect would persist in professionals, due to the erosion in profitability it would cause. In structured experiments, professional baseball card traders showed a steady reduction (to extinction) of the endowment effect as they traded over many rounds.
5 However, it remains unclear whether the endowment effect is reduced through experience in stock market participants.
NEUROSCIENCE OF LOSS AVERSION
If loss aversion is so common, affecting almost two-thirds of investors, then it’s reasonable to speculate that it may have a biological basis. Chapter 14 described an fMRI study in the United Kingdom that identified amygdala activation (fear) as one cause of the effect. Interestingly, loss aversion and the endowment effect are evident in the behavior of monkeys.
An enterprising economist, Keith Chen at Yale University, trained capuchin monkeys to use and value “currency” (small metal tokens). He observed the choice behavior of his monkeys during a number of different decisions, in which they chose among different quantities of one of their favorite foods—apple slices. Chen wondered whether biases such as loss aversion are the result of social or cultural learning, specific environmental experiences, or some fundamental neural process shared by all primates.
6The tufted capuchin is native to the South American tropics. Capuchins live in a male dominance hierarchy with a single alpha-male and several nondominant males and females living in small bands. Capuchins are “extractive foragers”—they prefer easy-to-eat fruit but when pressed are capable of pounding apart hard nuts, stripping tree bark, raiding beehives, and even killing small vertebrates.
7The capuchins were presented with choices between different quantities of apple slices. Some choices were framed as gains and others as losses. Chen found that the monkeys obeyed many of the axioms of prospect theory, for example. “Capuchins seem to weigh those losses more heavily than comparable gains, displaying not just reference-dependence but loss-aversion.” Chen concludes that “our results may suggest that loss aversion is an innate and evolutionarily ancient feature of human preferences, a function of decision-making systems which evolved before the common ancestors of capuchins and humans diverged.”
It’s not just tropical monkeys that are susceptible to loss aversion. Human children, while unable to express gambles in terms of expected value, also demonstrate loss aversion, with no age-diminishing influence through college.
8
THE EQUITY PREMIUM PUZZLE
The equity premium puzzle refers to the historically high returns of stocks relative to bonds. According to economists, the average annual real return (i.e., the inflation-adjusted return) on the U.S. stock market for the past 110 years has been about 7.9 percent. In the same period, the real return on a relatively riskless security was 1.0 percent. The difference between these two returns, 6.9 percentage points, is the equity premium.
9 Why U.S. bonds are so popular, even with a relatively low yield, is the puzzle. Individuals must perceive a significantly higher level of risk in stocks than has been shown historically for the puzzle to be reconciled with “rational” economic models.
10Investors are sensitive to volatility, and the more they check prices, the more risk they see in the stock market. When experimenters change the feedback frequency of price quotes, they find that individuals tend to invest more in equities when the performance of their prior decisions is assessed less frequently (i.e., when they see price quotes less often).
11Professors Shlomo Benartzi and Richard Thaler at the University of Chicago proposed that this feedback-induced conservatism was due to a process of “myopic loss aversion.” As people receive more frequent feedback about price changes, they become short-sighted in their risk assessments. Given their more numerous sample periods, frequent price checkers have higher odds of seeing negative price changes, which they perceive as threatening (risky) to their wealth. Thaler argued that the size of the equity premium (6 percent) is consistent with investors evaluating their investments annually and weighing losses about twice as heavily as gains.
12Investors’ myopic loss aversion is increased by exposure to both information quantity and frequency. Loss-averse clients may have compelled Israel’s largest mutual fund manager, Bank Hapoalim, to change the frequency of its fund performance reports from every month to every three months, while noting that “investors should not be scared by the occasional drop in prices.”
13In an experiment comparing university students and pit traders from the Chicago Board of Trade (CBOT), traders actually exhibited
more myopic loss aversion than students.
14 Floor traders may have honed a skill for rapid risk/reward assessment, which encourages short-term evaluations and decisions—not necessarily compatible with choosing the best long-term option.
Along these lines, researchers have found that professional traders and investors are largely incapable of arbitraging psychological biases out of market prices. Price anomalies such as the equity premium puzzle have persisted despite the recognition of greater profits available to investors who understand them.
So what would a savvy investor do? They should put all their long-term savings in equities, none in bonds or cash. Unfortunately, this advice is easier said than done, which explains why the equity premium has persisted.
THE IMPLIED PUT OPTION
In early 2006, Brian Hunter, a 32-year-old physics and applied math graduate from Calgary, Canada, placed large bets on the convergence of long-dated natural gas contracts (such as the March and April 2007 expirations). As the prices of those and other contracts diverged in September 2006, and Hunter lost more and more money, he repeatedly increased his risk exposure. By September 2006, Hunter’s firm, Amaranth Capital, had purportedly lost more than $6 billion (out of a total capital pool of $9 billion). The firm subsequently closed, liquidated its positions, and the remaining assets were returned to investors.
15In 2005, Hunter earned $75 million for his stellar trading performance, with a rally in natural gas prices due to Hurricane Katrina responsible for the bulk of those gains. While his lifetime trading gains had been spectacular, in 2006 investors in his firm lost 66 percent of their capital.
Hunter was exceedingly profitable for several years prior to the collapse of his fund, yet he may have grown overconfident in his ability to manage risk. He increased his risk exposure as his losses first swelled in May 2006. Fortunately, his gambit paid off during the summer of 2006. However, Hunter remained excessively exposed when markets again reversed in September 2006, and this time he didn’t get bailed out. The same pattern of loss averse trading characterized John Meriwether, the founder of Long-Term Capital Management. In both cases, each trader increased risk exposure when losing (loss aversion). Because they couldn’t accept the pain of the loss, they held on longer. Occasionally, loss averse investors even “double down” with more capital while insisting that their losing positions are rational.
Hedge fund traders who take excessive risk operate with an ethical dilemma in mind. They are working with an “implied put option,” which means that they are extremely well compensated if they take large risks that payoff, but a catastrophic loss is unlikely to affect them beyond the current year (unless they invested in their own fund). The worst that can happen to them personally, especially in a hedge fund, is that they lose their job, their current income, and any forthcoming annual bonus. In the case of Hunter, he made $75 million in 2005, and beyond the one-third of his bonus that he had invested in Amaranth, he will emerge from the debacle with tens of millions in the bank from his trading in 2004 and 2005.
16 Not bad for someone who lost $6 billion in 2006.
One especially interesting aspect of Hunter’s success and subsequent downfall is the respect and admiration afforded him by other traders. According to “former Deutsche Bank colleague Bruno Stanziale, 34, ‘He has an understanding of the market that others do not.’” Another former colleague remarks that Hunter should get back into trading, “‘Otherwise, it would be too much intellectual capital wasted to have him on the sidelines.’”
17 Similar praise was conferred on John Meriwether after the collapse of Long-Term Capital.
While there is no doubt that both Hunter and Meriwether are remarkable men, it is surprising that many traders miss the essential lesson of their downfalls. A few years of hefty profits and sagacious market insights do not immunize traders from the risk of total collapse. Risk management is key, yet it is often boring and restricts profitability. Firms that are trapped in a death spiral will often take far more risk to get out of their hole. Often, “doubling-down” works, and then an “addiction to risk” can become entrenched.
Interestingly, it is excessive risk taking when losing that also characterized the downfalls of “rogue trader” Nick Leeson at Barings Bank in Singapore (in 1994) and Toshihide Iguchi at Daiwa Bank in New York City (1995). Like Hunter, both Leeson and Iguchi had been considered “stars” of their firms and as such had been given less risk management oversight.
OVERCOMING LOSS AVERSION
“I was determined to win back the losses. And as the spring wore on, I traded harder and harder, risking more and more. I was well down, but increasingly sure that my doubling up and doubling up would pay off . . . I redoubled my exposure . . . it became an addiction.”
It doesn’t feel good to take losses, but it has to be done. Following are a number of tips for investors and traders who have noticed loss aversion in their transactions (avoiding selling losers, “doubling down,” and “hoping for a comeback”). In truth, the result of doubling down may be a rebound in one’s positions and greater overall profits. But, eventually, the rebound will not come, and one will lose everything.
Loss aversion usually dissipates with experience, and the following tips should help yours along into the dustbin of history. Many of the tips are repeated elsewhere in the book.
1. When you reevaluate your investments holdings, consider preferentially selling some of the losers instead of the winners. Ask yourself, “All things being equal, would I enter this position today?” If your answer is “no,” then place it on your sell list.
2. Be aware of rationalizations or excuses you make in order to hold a losing position longer. Many traders who break their stop-loss rules report that they wanted to “see if it would come back a little before I sold it.” Don’t believe yourself—while you were waiting for that retracement, you were rationalizing your poor money management. You didn’t want to take the pain. It takes a lot of courage to admit defeat. And you can’t regroup for the next engagement until you’ve taken the pain.
3. Beware of letting naked options expire worthless instead of selling them according to plan. It is easy to let out-of-the-money options or long-dated “low-risk” arbitrage positions sit, hoping for a comeback, rather than selling them for a loss. On a similar note, when shorting stock, be sure to have a stringent (and realistic) sell criterion.
4. Remember that you are more susceptible to loss aversion after recent or large losses of any nature. Be aware of losses and disappointments in your life and how these may affect your investing.
5. Humility is essential. Developing a reputation as an excellent or insightful trader could make you cocky. When you are eventually wrong, you’ll be less likely to admit it, for fear of damaging your reputation. Remember, the markets are always bigger than you.
6. Be sure to set and follow stop-loss rules. If you don’t have a defined money management system, then be sure to put one in place. See number 1 above.
THE HOUSE MONEY EFFECT
Most investors are susceptible to investing errors related to loss aversion, such as holding losers too long. Not as many investors cut their winners short. In particular, a seemingly contradictory mistake has been noted by researchers. Professor and money manager Richard Thaler found that many of his experimental subjects took increased risk after wins, which he called the house money effect. The house money name is derived from an expression often heard at casinos, where gamblers who bet more after big wins are said to be playing “with the house’s money.” They have not yet internalized their ownership of the winnings yet, and thus they aren’t as afraid of losing it.
This contrast between “cutting winners short” due to loss aversion and “letting winners ride” due to the house money effect is frankly confusing. The existence of these two seemingly contradictory biases can be attributed to the framing of prior gains. According to professor and behavioral finance expert Hersh Shefrin, “If a prior gain is followed by a gamble whose maximum loss is not larger in absolute value than the prior gain, then a person might act as if he or she is risk seeking in the domain of gains, in contrast to a situation where there was no prior gain but the underlying cash flows were the same, and the person was risk averse in the domain of gains.”
19,20 If one is struggling to maintain a profitable trading account, then gains are quickly realized (cut short) in order to cement the account in positive territory. However, if an investor is flush with excess cash, then risks will not be as worrisome, and gains will be left to “ride.”
Researchers have identified the house money effect among market makers on the Taiwan Futures Exchange. Every options transaction on the exchange between 2001 and 2004 was analyzed.
21 Market makers were found to take more risk in the afternoon after a successful morning of trading. Other studies with individual investors have often found the same effect ; they increase subsequent trading intensity and take on greater risks after making profitable trades.
22 Among investors, the house money effect is often present among more successful individuals. That is, more successful investors are more likely to let their winners run. However, the effect does appear to decline with experience.
As noted in the quotation from Hersh Shefrin above, an investor’s frame of reference regarding recent gains or losses often determines which type of bias they show. Investors may become excessively loss averse if they are worried about giving back profits, while they may become excessively risk seeking if they feel that they have “nothing to lose.” In each case, feelings about potential gains and losses are driving risk-taking. In the examples of professional investors below, notice how each prevents himself from interpreting gains and losses in ways that provoke an emotional response.
LESSONS FROM THE POPE
Jim Leitner, manager of Falcon Management, a New Jersey-based hedge fund, is considered by some to be the “Pope” of global macro investing. By his own estimate, he has taken $2 billion out of the markets for himself and his employers over the course of his career. Leitner is hardworking, humble, intellectually curious, and willing to sacrifice in the short-term in order to advance his experience or knowledge. Since founding Falcon Management in 1997, he earned approximately 30 percent annually. Author and hedge fund consultant Steven Drobny interviewed Leitner to discover some of his investing secrets.
23When asked how he can tell when prices are out of line, Leitner responds, “I don’t have an innate skill. It comes from being extremely interested in markets and looking at everything all the time.” Through his interest and experience, Leitner has developed a “mental database of where things should be.”
24 In a sense, Leitner has honed his ability to assess expected value and notice deviations from it on his mental “radar screen.”
As a result of his innate evaluation mechanism, which is driven by factual events and prices, not by overt feelings, Leitner describes his trading as being “absolutely unemotional.” “Losses did not have an effect on me because I viewed them as purely probability-driven, which meant sometimes you came up with a loss.
... To this day, my wife never knows if I’ve had a bad day or a good day in the markets.”
25How does Leitner remain unaffected by his performance? His ego is uninvolved, because he remains unattached to outcomes. In addition to being unemotional: “
. . . I’m really humble about my ignorance. I truly feel that I’m ignorant despite having made enormous amounts of money.” Leitner is never trying to prove something with his ability to make money. He approaches investing as an intellectual game, one that he loves to play. Leitner describes his favorite trade as one in which he made one tick overnight on the Swiss franc by relying on his wits, “
... My wife still remembers me jumping up and down in the middle of the night screaming ‘I did it! I did it!’
... It was the most phenomenal feeling of control and creativity all coming together.”
26Leitner displays no hubris or overconfidence in his interview—only an intense curiousity about the markets, humility, and a willingness to constantly reexamine his assumptions. He does recount an episode when he forgot to be humble: “Finland devalued once when I was working for myself and I was caught long. I was partially asleep and a bit cocky because it had never happened to me before. The trading gods had to remind me to be humble.”
27For the aspiring investor, Leitner recommends openness to the “entire spectrum of market experiences,” avoiding becoming too much of an expert, and learning not to “buy into stories.” To combat the “buying into stories bias,” Leitner suggests, “We need to quantify things and understand why things are cheap or expensive by using some hard measure of what cheap or expensive means.” Yet we shouldn’t dismiss stories. “A story is still required since a story will appeal to other people and appeal is what drives markets. ”
28Leitner practices looking at both sides of an issue, essentially balancing his frame of reference. He is aware of the psychological confirmation bias that drives many investors to seek only information that supports their beliefs. “Very few people train themselves to look for disconfirming evi dence.
. . .What I try to do in my trades is look for disconfirming evidence. It’s a very difficult practice, and I have to continually train myself to ask why I believe something is going to go down, not why it should go up.”
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COMMENTS FROM SOROS, TUDOR, AND CRAMER: “BOOYAH!”
“I think I am the single most conservative trader on earth in the sense that I absolutely hate losing money.”
“Rule No.1: Never lose money. Rule No.2: Never forget rule No.1.”—Warren Buffett
If most investors are susceptible to loss aversion, then how can they get over it? According to a paper by Professors Seasholes and Feng at the University of California at Berkeley, investor sophistication (measured by trading characteristics such as portfolio diversity) and trading experience together eliminate loss aversion over time. Trading experience alone does not account for extinguished loss aversion—sophistication must also be present. One unusual finding of their paper was that sophistication and trading experience reduce the propensity to realize gains somewhat (by 37 percent) but not entirely.
31 Even professional investors, with extensive experience, may be playing scared—and cutting winners short.
George Soros announced the closure of his largest equity funds—Quantum and Quota—at the peak of the technology bubble. His portfolio manager, Stanley Druckenmiller, commented that stock markets in late April 2000 were, “now crazy insane, unbelievably dangerous.”
32 Regarding their departure from the stock market, Soros commented, “Being the last in, we felt it incumbent to be the first out.”
33 By being first out, Soros was displaying an eagerness to realize his losses and get out of a market that he no longer understood.
Paul Tudor Jones is one of the greatest traders in history. In Jack Schwager’s book
Stock Market Wizards, Jones comments on how his life and trading have changed since a large loss he suffered during one of his first years as a professional trader: “Now I spend my day trying to make myself as happy and relaxed as I can be. If I have positions going against me, I get right out; if they are going for me, I keep them.”
34 Jones optimizes his mental state during the trading day by reducing emotional interference, and one way of doing that is by cutting losers quickly.
Jones tackles the framing bias that leads to loss aversion by daily updating his frame of reference: “Don’t be too concerned about where you got in to a position. The only relevant question is whether you are bullish or bearish on the position that day. Always think of your entry point as last night’s close.”
35 Price changes are unimportant. Is there new information (besides price changes) that alters the fundamental outlook?
Jones offers suggestions on preventing trying to make back prior losses. “Don’t average losers. Decrease trading volume when you’re trading poorly. Increase volume when you’re trading well.” In order to preempt any urge to hold on too long when a position isn’t moving, Tudor recommends, “Don’t just use a price stop, use a time stop. If you think a market should break and it doesn’t, get out even if you aren’t losing any money.”
36On March 11, 2000, days from the all-time high of the NASDAQ, James J. Cramer, former hedge fund manager, founder of
TheStreet.com, and currently star of CNBC’s
Mad Money, rewrote his wife’s 10 trading commandments. The first of those commandments urged disciplined selling of losers:
Discipline is more important than conviction. My wife’s trading was all about fallibility. She knew that a lot of her ideas would be stinkers, even if she believed in them. So she had ironclad rules. Don’t let emotions get in the way. Don’t ride things down. Don’t get smitten. 37
Discipline is all-encompassing—it stops every emotional bias in its tracks. In the above quoted article, Cramer went on to recommend that investors (in March 2000) take money out of the markets, explaining they would thank him later for that advice.
The professionals above use analytical detachment from profits and losses, engage in strictly disciplined selling of losers, and cultivate humility in order to prevent the emergence of emotional biases such as loss aversion. In the next chapter you’ll see one effect of emotion on thinking—time discounting and the pursuit of immediate gratification.