Wednesday, June 07, 2006

Challenging conventional wisdom

As investors, it's important - if we want to outperform the indices - to think differently. And that means challenging accepted conventional wisdoms, by continually asking questions that reveal underlying assumptions. Also, looking at the quality and quantity of the data before us, can also help us become better investors too.

I enjoy reading articles that consider common investing mistakes, so that I can hopefully minimize these mistakes myself. One recent one I read (by way of Abnormal Returns) was a list of 15 common biases reported at The Kirk Report, from the investor magazine, Trader Monthly. The list is full of good stuff.

But I finally (i.e. years late) suffered some cognitive dissonance when reading item #12 on the list ...
12) Asymmetry of risk tolerance: Investors are risk-averse with regard to gains (preferring to sell "winners" and ensure the gain) but risk-takers when it comes to losses (preferring to hang on to "losers").

Now this isn't the first time or place that I've read this statement, but I finally realized that this is in complete contrast to two other accepted wisdoms I've read multiple times over the years:

a) That investors in mutual funds - in the aggregate - underperform the performance of the mutual fund itself, primarily because they pile into the latest hot fund (whose performance decays thereafter), and

b) That reversion to the mean exists, meaning that stocks and mutual funds that have underperformed for a relative period, generally outperform in the following period.

Something has got to give - all of the above statements cannot be true. While I'm not certain which of the three has to give, I personally think it's the first one. Having seen more than a few investors, I tend to believe that a) is true, and by reasonable extrapolation, also applies to most other investors (i.e. not just those who invest in mutual funds).

I've also seen a fair number of studies showing that underperforming stocks rebound typically have a rebound (because they got priced too cheaply) and outperforming stocks often falter (because they became too expensive ... "priced for perfection). So I tend to think that b) is also true.

So, I'm going to say that I think bias #12 is probably false - and I think in fact it might be the opposite - investors holding "winners" for too long, and dumping "losers" too early.

But what do you think?


The Confused Capitalist


muckdog said...

Just like investors chase the hottest stocks, they tend to buy high and sell low. Folks were bullish in early May when the market was making new bull market highs, and now they're bearish as the SP500 pulls back to the 200dma.

And this happens over and over again. That's the amazing thing.

Found your blog via a comment you made at Random Roger.

quints said...

I think #12 is correct. I had a neophyte investor friend who watched everyone making money hand over fist in 1999 so they jumped in at a bad time. As soon as he lost about 5% he was out. He could not take the fact that he had given up $300 (Out of a $6000 stake) that he could have spent. It was real money lost and it was magnified because it was money that he had owned. I think there is something to #12.

Anonymous said...

I think it depends on the situation. If I have a strong belief in a story about particular position, I will allow more leeway for the position to fall. If the market is fighting the position I have taken, I will surrender much faster. Japan is a perfect example right now. I believe in the long term story of Japan's recovery and that the dollar will weaken against the yen. That bodes well for EWJ for example. I stopped out of a position with this last fall off and will repurchase it again when I think the time is right to ride it higher again. It isn't life and death stuff but it is kind of fun to try to see these longer term trends and make some money out of them. Sometimes chicken, sometimes feathers. Tom in Indiana