Category: Investing Psychology

Don’t Fall for the Safe Position Fallacy

by smallivy, posted in Investing, Investing Like a Pro, Investing Psychology, Investment Strategies, Serious Investing

jehericotopfalls

People like to win and hate to lose.  Basic in the psychology of people who are investing is the idea that if you make money on a position, you have won, but if you lose money, you have lost.  You also see silly ideas like “You don’t lose money until you sell.”

“You don’t lose money until you sell.”  Bad advice.

I’ve found that I’m subject to the same impulses.  When I was younger, I used to sell a stock if I made a certain gain.  For example, I would sell if I made $1,000 so that I could “take a safe position or  “lock in the gain” and eliminate the risk of the position turning south and turning into a loss.  Because I was taking a gain, I had “won,” but if I let the money ride and the stock went back down, I would have “lost.”  Chock one up for the “w” column.  Nevermind that I had to put the money somewhere else and possibly take a loss there.  I was a winner.  This behavior meant that I sold my gainers and held onto my losers.

Because I didn’t want to take a loss, which would then mean that I would “lose,” I held onto the losers, waiting for them to at least get back to the price at which I bought them.   Sometimes I’d hold them and they’d continue on down until I finally sold them in despair or just stopped looking since they weren’t worth enough to sell and pay the commission. Sometimes they would go back up to where I bought in eventually after a year or two of waiting.  Then I would quickly sell because, according to my ludicrous logic, that way I didn’t lose any money.  I didn’t “lose” since I got out what I put into the stock.  Now, in reality, while I had the same amount of money, perhaps a year or three had passed. Those dollars didn’t buy as much as they did when I invested them, so I was still losing money. Even worse than the loss to inflation, however, was the loss of time. I lost the ability to grow my money over those two or three years in a good stock because I refused to sell a loser.  I just ended up even after that time period instead of seeing gains.

After a few years of doing this, selling winners and holding losers, I ended up with a portfolio of stocks I didn’t really want.  I’d sold the stocks that were doing well and probably continued to climb.  I held the bad ideas and the poorly run companies, selling them if they actually turned around just as they started doing well.

In investing, there is nothing as important as time.

If you’re a serious chess player, you know about something called “tempo.”  Controlling the tempo means that you get to choose your moves and your opponent needs to react to what you do.  This keeps him or her from being able to do things that you don’t like.  Someone set back on their heels all of the time can’t throw an effective punch.

Time in investing is important as well.  Investments grow with time, and you make the most during the years at the end when you have the most money.  Each year at the end can mean hundreds of thousands or even millions of dollars in additional wealth.  At the beginning, when you first start investing, it may seem like you have all of the time in the world, so waiting for a stock to turn around doesn’t matter.  Waiting to start investing is even worse.   When you’re young and have fifty years ahead of you, you’ll figure it won’t matter if you wait five years to start investing.  You’re wrong.  At the end, you’ll wish you had just five more years before retirement.

Selling your winners early costs time.  Plus, you’ll still need to put that money somewhere, so you really aren’t reducing risk

When you sell, you need somewhere to put that money.  If you leave it sitting on the sidelines, you are losing time.  You never know when the next huge run-up in stocks will come, and you don’t want to be sitting on the sidelines in cash when that happens.  Selling just because you have a gain may mean getting out of a great company just when they are starting a big climb and putting your money into a stock you don’t like as much.  You might also be buying a stock ready for a fall because it has just completed a big climb and become overbought.

Another strategy is to take a “safe position.”  Here you sell a few of your shares so that you now have gotten out all of the money you invested, leaving a little in case the stock continues to climb.  That leaves you needing to move the money you made “safe” somewhere else, putting it at risk again.  The other choice is to leave the money in cash and be losing money to inflation each year it is not invested.  Why leave a company that is doing well and perhaps you really like to buy into another one that you don’t like so much?

Holding your losers costs time.

Every year you sit holding onto losing positions for them to go back up to where you bought them is a year you could have invested in something that was growing.  There are times when a great stock will go through a sell-off, or a company will drop in price as they reorganize and wait for their industry to recover.  There are also times when the whole industry or the whole economy declines, causing some great stocks to go down in price. Oil producers are in just this position right now, the good and the bad.  These stocks should be held and perhaps your positions added to during the downturn.  This is different, however, than holding stock in a company that is performing poorly and will continue to perform badly, waiting for it to recover.

I did this with Cisco stock, holding from about the year 2000 through about 2012, waiting for it to recover and grow.  I eventually sold the stock I had bought for about $20 at $30 or so.  True, I made a 50% profit, but I should have seen my money double or even quadruple in that period of time.   I lost all of that time when I could have been invested in a growing company instead of an old, tired, bureaucratic company whose time has passed.

Churning is costly.

When you sell a winner, you need to pay brokerage commissions (both for the sale and for the purchase of something else).  You also need to pay taxes on the gain, perhaps at a rate of 25-40% when you include federal, state, and local taxes.  If you stay invested, the money rides tax deferred until you sell.  This means your money, even the money that would have been paid out in taxes, compounds.  Over a lifetime, this could be hundreds of thousands or millions of dollars.  (I use that phase a lot, don’t I.  This is a costly thing to get wrong.)

Got a question or comment about personal finance or investing?  Please leave a comment.

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Disclaimer: This blog is not meant to give financial planning or tax advice. It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

Why No One Ever Won Deal or No Deal Revisited

by smallivy, posted in 401K Investing, Investing, Investing Psychology, Personal Finance, Retirement Investing

Space Capsule

Without a doubt my most popular post of all time is:  “Why No One Will Every Win A Million Dollars on ‘Deal, or No Deal.'”  I get thirty or forty views of this post per day, although I’m not sure why.  Part of me wonders if some sort of scam is involved, but I can’t see how.  I guess there are just a lot of people searching for “Deal, or no Deal” and the post comes up high on the search engines for some reason.  One of the oddest things is that the post has been rated 2 1/2 stars, which is between poor and average.  I’m not sure why so many people are reading a post they don’t like.

In any case, some people seem to be missing the whole point of the post.  The important thing is not the rules for Deal, or No Deal, or whether someone actually won the $1 Million.  (Two people did win the $1 Million in 2008, but those were in games where there were five $1 Million prizes instead of just one, increasing the chances and changing the psychology of the game since there was a chance of having two or more million dollar cases remaining near the end.)  One person even commented that the show was off the air by the time I wrote the post, so of course no one would ever win.  This is not really important for the message I was trying to convey.

The way that the game was designed was ingenious because it would be extremely unlikely that anyone would ever actually win the million dollars. Even winning $500,000 was very unlikely. That is because it combined a very low chance of selecting the right case as “your case” with the psychological factor of people not wanting to give up something valuable, like a $250,000 offer from the banker, for the possibility of a something better, like a million dollar case, since the consequences of being wrong would be severe.  The reason is that they calculate how much they will lose if they don’t get the better thing and that weighs on them more psychologically than does the calculation of the increased benefit if they win.  The humiliation of being wrong in front of a lot of people then adds to the stress.

It would be a whole different show if people were just selecting cases randomly and getting whatever was in them.  By the odds, someone would win the million dollars within a couple of seasons.  Having the banker there, throwing out offers, is what makes it so unlikely for someone to win the $1 Million.  It would take both a person who was really lucky and selected the $1 M case at chances of 1/30, and who was willing to risk losing a lot of money for the chance to increase their winnings modestly.  Once the banker makes the offer, that money is in their pockets and they need to give it up if they want to continue.  How many people, given a sure $300,000, would decide to go for the million when they would only win $200 if they were wrong?

This same psychology comes into play in investing for retirement and helps explain why most people get nowhere near the final 401k account balances you can calculate they’ll get when they’re 20 years-old assuming a 10-15% return from stocks over their whole investing career.   Most people from moderate incomes don’t retire with $8 M even though those are the kinds of outcomes you see when you punch the numbers into an interest rate calculator.

The reason is that once they have $500,000 or so, they start to do things to preserve that money that are smart from a risk-reduction standpoint, like shift into bonds and cash, but which reduce their returns.  They may also do foolish things that go against all of the proven studies like pull out of the markets when they get worried that stocks are overpriced and then miss the big rallies.  If you’re not there for the big rallies in the stock market, your returns will go from 15% to 2% in a hurry.  Most of the money is made over short periods of time.

Because with compounding you make most of your money in the last few years, which is right when people tend to get skittish and shift out of stocks or start trying to time the markets, most people end up with far less than they should statistically.  For example, someone who is 50 years-old and has $500,000 in a 401k may start to worry about a market downturn and shift into cash or bonds.  This is a reasonable move since the stock market can fall by 50% or more at times, turning that half a million dollars into a quarter million dollars in the span of a month or less.  Left alone after a downturn, however, the account would regain its value within a year or two during all of the market crashes we’ve seen for the last thirty years and then continue to gain enough value to provide the 10-15% returns cited.  $500,000 will double three times between age 50 and age 70 at about an average 10% return, turning into $4 M.  If the investor at age 50 went half into bonds with a return of around 5-6% and continued to reduce her exposure until retiring at 70, the account might well be worth $1 M or less.

My point is that to give yourself a chance at making the high returns you really should, and get over the reasonable fear of a market downturn, is to save and invest more when you’re young so that you can put enough money aside for retirement in ways to preserve it to be safe, yet still have a lot invested in stocks to get the superior returns that come with equities.  You certainly don’t want to have everything riding on the stock market when you’re close to retirement since a market downturn can then result in a delay of retirement or, even worse, retirement in poverty should you lose your job or get ill and not be able to continue to work.  If you have $2 M in your 401k when you’re fifty-five years-old, however, you can diversify $1 M as you would if that were the only money you had and needed to preserve it (assuming that you needed about $1 M to cover your expenses in retirement), and then let the other $1 M be fully invested in stocks for the better returns.

In this case you might have $1.5 M in a diversified set of stocks (half of the $1 M you were preserving as if it were your only money plus the extra $1 M you had), with the other half million in bonds and cash investments.  If the market takes a 50% decline at age 56, you would still have $1.3 M or so.  You could then wait for the market to recover, which it most likely would and then some well before you reached 65.  You would have a good chance of seeing that $1.5 M in stocks double at least once before you reached 65, so you could retire with about $4 M, including your returns from bonds.

Once you were in retirement, you could continue the strategy with keeping as much of the account in wealth-preservation, modest growth mode as needed to cover your needs and leave the rest invested.  When the stock market did well, you could use a portion of returns from the stock portfolio to do extra things like travel or fund college accounts for grandchildren.  When there were market downturns, you could just adjust the wealth preservation portion as needed and leave the rest invested, waiting for the recovery.  With a little extra savings, you can take the banker’s offer and be able to go for the million dollar case too!

Got and investing question? Please send it to vtsioriginal@yahoo.com or leave in a comment.

Follow on Twitter to get news about new articles. @SmallIvy_SI

Disclaimer: This blog is not meant to give financial planning or tax advice. It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

Are You Holding An Asset from Sentimentality

by smallivy, posted in 401K Investing, Diversification, How the Rich Invest and Handle Money, Inheritance, Investing, Investing Psychology, Retirement Investing

OLYMPUS DIGITAL CAMERASentimentality is a powerful emotion.  My family laughed when I insisted we pass by the home I grew up in not once, but twice the last time I went back to my home city.  I’ll also swing by old apartments, schools, campsites, and other places where I spent a significant amount of time or even a memorable evening.  When I proposed to my wife, I wanted to do it on Shelter Island in San Diego at a gazebo where we had danced to music from my boombox a couple of years before.  The gazebo apparently was in disrepair and had caution tape around it — it’s actually gone now — so I got down on one knee beside it.

One issue with sentimentality is that it often causes us to keep things long after we should have let them go.  This can clutter up our homes, cause us to have two of many things, and sometimes cause us to use items long after their lifetime has expired when we could have a new, shiny one for a few dollars.  With investing, holding on to an asset through sentimentality can be devastating.

My father once told me to never fall in love with a stock.  While long-term investing is good, sometimes when we’ve owned a stock for a long time we become sentimental about the stock (or other asset).  We then become blind to the fact that the company has changed and hold a large position in a company right from the peak down to the ashes.  We also might become  so convinced that the company is good and will turn around that we’ll continue to plow money into it even as it is going under.  Despite giving me this advice, even my father fell into this trap, holding onto a company that he had seen double for years and years after a new CEO was appointed that radically changed the company and drove it into the ground.

Probably the most dangerous time where many people fall into the sentimentality trap is when there is a death.  Watch an episode of Hoarders and you’ll see that many of the people who now have paths through their homes among piles of possessions started their hoarding after a death.  They ended up keeping everything the person had in an effort to hold onto their memory.

While many people keep clothes and personal items out of sentimentality, which results in clutter and full closets, keeping assets out of sentimentality can cause financial damage.  For example, we keep our parents home and rent it out, even though we live in another state, and end up paying all kinds of money to travel to the home and deal with the issues that require us to be at the home.  We would never buy a home in another state in order to rent it, but we hold onto our parent’s home because we’re sentimental, and in doing so make a bad financial decision to have a rental property that is hard to manage and possibly a bad rental property as well.

Another thing that might happen is that a relative has a lot of shares in a stock that we end up inheriting.  Because the stock reminds us of that relative, we hold onto the stock even though it is way too much money to have in one stock.  If something goes wrong at the company, we risk losing the full value of that stock.  If we had sold instead, we could have used the money for something useful, or even invested the money so wisely so that it would pay us income for the rest of our lives.  The issue is that by having the stock, we remember that relative and we want to hold onto the stock to hold onto a part of him or her.  If we sell it and spend it, or even sell it and just add the cash to our regular portfolio, we lose that connection.

Probably the best thing to do in this situation is to still keep the money together to keep the memory, but either spend it in such a way that you can preserve the memory or invest it together in a way where you still reduce the risk.  One way to spend the money but still hold the memory is to buy something permanent with the money such as pay  in off your home, make a home upgrade, or even buy a vacation home or other luxury.  That way each time you see the item, it will remind you of the person.  If you are going to invest, you could buy a less risky single asset, such as a local rental property, or a single asset that is diversified in itself such as shares of a mutual fund.

One of the best things you can do with an inheritance such as this is create a separate asset for which you use the income for a special purpose.  For example, you could buy shares of a mutual fund and then sell off 10% of the mutual fund each year for a home improvement.  Maybe replace a floor one year, then buy a new couch the next, and so in.  In this way it is like the relative is giving you a gift each year.  As long as the amount you take out each year is modest (maybe between 5-10% from a mutual fund), the relative will keep “giving you gifts” for many years.

In our case, I received money from my Uncle David from a life insurance policy.  Rather than putting the money into our portfolio where it might get lost, I put it into an index mutual fund.  Each year we withdraw 10% and take a special vacation we call the “Uncle David Trip.”  It is not a huge amount of money, but enough for maybe a weekend at a nice hotel or even a week on the road staying in low-cost motels.  By doing this, we can share time as a family and remember my uncle while doing so.  This is much better than an holding onto an old shirt.

Disclaimer: This blog is not meant to give financial planning advice, it gives information on investment strategies, stock picking, and other matters relevant to the investor. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.