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Stock Lab
Do you have a profitable personality?
Toni Case - December 3, 2007
Most of us know someone who has a knack of making money. Whether we call it the Midas touch, or just good luck, making money comes easy for some people and almost impossible for others.
There is a personality type that makes winning investment decisions constantly, and tends to make money with ease. This person is the type to buy a brick-veneer "renovator’s delight" on the outskirts of town for a song, only to sell it two years later for a six-figure price tag. Or the type of person to buy gold before the bull run, a takeover target months before the market finds out and the share price spikes, or a vintage wine that suddenly becomes the flavour of the month.
Why is it that some people make the art of investing seem so easy?
It could be said that some people sport a profitable personality. These people gravitate towards money-making opportunities but more importantly stay clear of areas of the market or specific investments that will fail to deliver over the long haul.
Having a profitable personality is less to do with nature, nurture or education, but more to do with mindset. Profitable personalities have the clarity of mind to spot opportunities that others don’t.
Behavioural psychologists have noted that many people make lifestyle, budgeting or investment decisions without actually thinking about it. We act on habit, or instinct, which can often lead us astray. A good example, that’s close to home, is filling our car with petrol.
Many people in Australia spend time driving past petrol stations and comparing the range of petrol prices on offer. It’s not uncommon for the typical Australian to drive across town in order to save 3 or 5 cents a litre on a tank of petrol. The thinking goes something along the lines of "well, I’m saving money and that’s a good thing right." But when you really think about it, on a 50 litre tank of petrol, we’re looking at a $1.50 or $2.50 saving on a 3 or 5 cents discount, not taking into consideration the extra petrol used during the hunt for petrol in the first place.
On the other hand, people tend to act differently when buying big-ticket items such as a flat screen TV with an $800 price tag. Whilst in the zone to fork out $800 for a TV, the average people couldn’t be bothered running around town looking to save $1.50. In fact, many are unlikely to care too much if the difference between two TV sets across town was $15, or $20. But we’re saving money, right? Isn’t that a good thing?
This is a common error in human thinking. In absolute terms a $1.50 saving on petrol should be viewed equally to a $1.50 saving on a TV set. But humans tend to compare things relative to a benchmark rather than in absolute terms.
This error in thinking is never more prevalent than in the realm of property. As a quick example, let’s look at Bill and Janice, married with no children. When Bill and Janice go out for dinner they select the $12 pasta meal rather than the $25 steak; Bill takes the bus to work outlaying $50 a week rather than paying for a $150 car space; Janice argues with her bank over a $20 fee; the couple decide against the overseas holiday for a week in Cairns. But when Bill and Janice decide to buy a house at auction for $650,000, they pay $100,000 more than they’d bargained for.
When you look at this scenario realistically, Bill and Janice constantly make small savings throughout the day, but were happy to fork out an extra $100,000 at auction day. At the end of the day, a $13 saving on pasta compared to steak is irrelevant in the light of paying out an extra $100,000 after tax on one purchase.
Behavioural finance academics and psychologists label these errors or flaws in human thinking as "cognitive biases". Apparently, humans are almost programmed to think badly when it comes to certain areas of our life and these common flaws in thought affect our decision-making. In the investment world, cognitive biases can be used to explain a range of phenomena such as why investors continually buy shares in a plummeting stock or sell shares just before a recovery. Behavioural science offers pointers on where investors go wrong.
Below we offer a couple of questions and answers. See if you fall into some of the traps that psychologists call cognitive biases. These are the types of stuff-ups in thinking that can separate a profitable from an unprofitable personality at the end of the day.
Question: If the sharemarket rose by 10 per cent next year, would you regard it as a bad year? Let’s put it another way, if your managed fund returned 22 per cent would you celebrate? Or if your favourite stock reported a 50 per cent rise in profit would you be happy with that?
If you answered yes to the scenarios above, think again. Why? Well, you are not basing – or framing – your opinions on anything other than a made-up baseline. For example, if you think that a 10 per cent return on the sharemarket isn’t too flash because the sharemarket posted a 20 per cent return this year, you should question why you’re using the current year as a baseline for your opinion. Instead, you should be basing your expectation on the long-term average return of the sharemarket, which is roughly 12 per cent. A 10 per cent return next year, in that sense, isn’t too bad.
Similarly, a 22 per cent return on a managed fund that measures its performance relative to a benchmark index that spiked by 33 per cent is a pretty poor result. Or a company that posts a 50 per cent rise in profit when it was projected that profits would rise by 120 per cent is a paltry effort. Whenever you form an opinion, check to see that you are basing your opinion on the correct baseline.
Question: Let’s say that a stock that you purchased in January is now 50 per cent higher, and you have made a handy profit on it. Would you sell? Conversely, let’s say that the stock is 50 per cent lower, which if sold – would see a gaping hole in your account. Would you sell?
The thrill of pocketing a profit forces many investors into selling shares that are performing well. On the other hand, the desire to avoid disappointment makes us stubbornly hold shares that perform poorly. The end result can be a share portfolio full of below-average returning shares.
This behaviour is also typical of amateur gamblers. Having suffered five losses in a row on the roulette wheel, a gambler forecasts that the probability of experiencing yet another loss must fall since the run has to come to an end. At each consecutive bet - after a series of losses – the gambler increases their stake believing that when the run does turn the increased stake should make up for prior losses incurred.
During market corrections many traders fall into a similar trap. Take the tech bust in 2001 as an example. A common flaw of those who lost money on poorly performing tech stocks was to buy more shares as the stock fell lower. The argument - lowering the average purchase price could transform a loss into a gain over time – was flawed. Unfortunately many learnt the hard way. Indeed, this strategy is a sure-fire way to losing much more than you bargain for.
Investors could take a leaf out of the professional gambler’s book. Professional gamblers reduce their stake after a series of losses, and actually increase their stake after a series of wins.
Of course, the first whiff of trouble doesn’t mean that you should be hitting the sell button. Whether buying and selling shares, investors always need a sound and researched reason for doing so.
Question: Are you more likely to buy a stock that is regularly mentioned in the press, or because your friends and colleagues are buying it?
While most will adamantly deny following the pack - or ‘herding’ as psychologists like to call it - it’s not easy to blaze a trail as an investor. We derive comfort from following the pack. We also spare ourselves the blame should the investment fail to deliver.
To make an independent investment decision – or to go against the grain - takes a concerted effort to research and analyse, and many investors (when it comes down to it) couldn’t really be bothered. They instead latch onto the popular stocks, just like everyone else. Most sharemarket bubbles are the result of pack behaviour, and the ensuing fallout is also a result of herding as investors head for the nearest exit. Investors must learn to think independently and focus on building a share portfolio to withstand the inevitable rises and dips of the market.
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More articles from this edition of CompareShares:
Superannuation: What will Rudd do with our super?
Investing Psychology: Do you have a profitable personality?
Stocks: Buying opportunities for transport stocks: BXB & RCY
Trading: The ultimate guide to trading shares for beginners - part 3
Stock of the week: Dip creates buy opportunity on hot construction company
Economics: Party economics: Australian-style
Outlook: Is an Australian recession on the cards?
Smart Investing: Choose your super fund wisely and retire wealthy
Markets: A volatile month for US stocks
Companies: Market believes Rio worth more, says CEO
Whatever your views, you can discuss this article - or any of Toni's articles - on our message board Your 2 Cents.
Toni Case is Australia’s first journalist to specialise on Contracts for Difference (CFDs). She was a staff writer for Shares, Personal Investor and Asset Magazines, and today is a regular columnist with the Australian Financial Review. She is a qualified financial adviser, and has an Economics (Honours) degree from Sydney University.
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