Emotional Distraction

by Jay Pestrichelli on September 12th, 2013

When it comes to investing, your emotions can lead you in the wrong direction.  We’ve talked about it in our book (actually 2 chapters dedicated to it) and on this blog. Today we’re going to talk about how your emotions can paralyze you into indecision. 
 
We have always said that the market is driven by fear and greed; which are two very powerful emotions. Someone’s decision to buy, sell or hold always comes down to fear of a bad result or greed driven speculation for growth. I’m not accusing everyone that invests to be greedy, but it is the nature of why we invest. If we weren’t interested in making our money grow, we wouldn’t take the risk.
 
As the stock market seems to have shaken off another potential sell off in August and get within 1% of its all time high, the question arises again: Should I sell or keep holding?  Remove hedging for a minute from this discussion…don’t worry, you know I’ll bring it back shortly.
 
Traditional stock investors have two choices after they've bought stock. They can hold that stock or they can sell the stock. If you don’t use options, those are your only two choices. So let’s use that as our base case.
 
Emotionally speaking there are two good outcomes for this stock owner: Holding the stock and it rises or selling and the stock declines. Both of those are perceived to be positive outcomes and should satisfy the investor. Conversely, there are two negative outcomes: Holding and the stock declines or selling and the stock rises. Some level of regret typically follows these events. Here’s a simple table to illustrate that:
You may not be aware, but study after study tells us that the intensity of regret felt from missing a gain is equal to the regret of actually experiencing a loss. However, actually missing a loss by selling stock before it drops is not nearly as satisfying as holding onto a winner.  If you’d like some actual data on this I recommend reading Brian Bruce’s Handbook of Behavioral Finance. There’s lots of good analytical data in here. Here’s an illustration of this phenomenon by adding some color to the table above. 
If you haven’t figured it out, here is where our emotions distract and mislead us. Consider the actual impact of a decision to sell or hold onto a stock position. If you decide to close a position, the two boxes in the Sell row have no real impact. Once you sell, who cares what happens to the stock price? You are out and worrying about what could have happened is irrelevant. The position is in cash and now you need some other place to park that money.  The regret of selling a stock that may continue to rise will only get in your way of making a choice.  Here’s the table now updated showing that the sell action now leaves the stock performance to be neutral on your actual value.
Crying over missed gains is regret you never have to experience because it’s now behind you. This doesn’t mean you shouldn’t learn from it, but that’s all it means to you. Modify your decision process if need be and move on. That’s just good practice to begin with.  By the way, we’re not saying don’t ever sell. We’re just saying don’t let the emotional “what if” impact that decision.
 
You’re now left with two scenarios that will have real impact on your position’s value once you’ve decided not so sell. We’re down to fear and greed again, so here is where hedging comes in.
 
By hedging, we remove much of the unknown impact a stock decline will have. And while it depends on what degree of hedging you decide on, you know there is a limit to your losses. This is one way to remove fear.
 
Of course there is a cost to being hedged and some of our gains will be expended on the protection, but that is just a fraction of an un-hedged portfolio’s downside.  One last time, here’s our table with some less intense emotional reaction to a HEDGED portfolio:
The emotions of fear and greed are based on real consequences of an un-hedged portfolio. No doubt about that. However, the fear of missing a gain or the satisfaction of missing a loss are only reactions in your mind and have no bearing on your actual portfolio’s performance.  That’s why we call them distractions and can give you more reasons to take unnecessary action.
 
So if you’re not sure whether to hold or sell your stock, just know you can remove some of the fear by being a little less greedy and paying for some portfolio protection with a hedge.


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