![KESHORN WALCOTT T&T’S OLYMPIC GOLD MEDALIST](/images/stories/london-2012/keshorn walcott gold.jpg)
Last week this concept was used to assess where T&T might have been after 50 years of independence had we done some of the things that other countries with circumstances similar to ours had done during the same period. In the context of the Olympics the counterfactual (“if only”) is felt more by the silver medalist than by the bronze medalist. The comedian Jerry Seinfield probably provides the best explanation in the following lines: “You win the bronze — you think, ‘Well, at least I got something.’ But when you win that silver it’s like, ‘Congratulations, you almost won. Of all the losers, you came in first of that group. You’re the number one loser. No one lost ahead of you!” Another scenario commonly used to explain the point is the question of being late. Do you prefer to be an hour late or five minutes? The closer you get to your intended target the easier it is for “what if” to enter the equation and these “what if” and “if only” questions creates a sense of regret. That regret will obviously impact your sense of happiness and well being. All of this may be good information, but this is a business supplement so you may be wondering what is the point of this discussion. Understanding the emotions associated with counterfactual thinking goes a long way towards forging an understanding of why people make the investment decisions that they do and further go on to repeat those choices over and over again even if it results in poor investment outcomes.
Feel Good
Terrance Odean, professor of finance at the University of California’s Haas School of Business, gave the following example:
“Suppose you sell a stock for $100, trading later for $120. If you buy it back, you’re going to regret it because it’s now more expensive. On the other hand, if it’s trading at $80, now you feel good because you timed it right. Investors choose what they buy and sell to some extent to manage their own emotions.” The key take away here is the investment choice is not about the hard and cold reality of trying to generate a return from the investment, often times the choice is about providing comfort to frayed emotions and this “baggage” can lead to sub optimal investment decisions. In the above example let’s assume that the stock was sold at $100 for a profit. When the stock falls to $80 the investor is pleased with the fact that they got the timing right having sold at a profit.
The investor would be inclined to re-purchase the stock at $80 even though the stock may have fallen from $100 to $80 because there were negative fundamental news about the stock in question. In such circumstances it is possible that the stock will continue to fall thus creating a loss position and eroding the earlier gain which made the investor so happy and contented. The emotion resulted in a sub-optimal investment decision. If the same stock had moved from $100 to $120 after the investor sold at $100 the investor now enters the counterfactual scenario where the “what if” and “if only” comes into the picture. Even though a profit was made on the sale at $100 there is the second guessing associated with the missed $20 of gains. The company in question may have reported good results and the fundamental valuation improved significantly to the point where analysts are now estimating a target price of $150. Yet despite that rationale the investor filled with regret at missing out on the $20 will ignore the potential $30 that is on the table and may be less inclined to re-purchase the stock. Once again the emotion resulted in a sub-optimal investment decision.
Professional Approach
Part of the job of a professional investor is to sidestep these emotions and focus on the quality of the company’s earnings at a point in time and the prospects for the company going forward. The value of the investment professional is to overcome the clouded mindset that emanates from counterfactual emotions. There is a concept known as dollar cost averaging. Every investor has heard the term before and it involves making steady dollar value investments over time (eg monthly) regardless of the market conditions. The investor purchases $100 worth of stock when it is priced at $2 per share and will purchase the same dollar value of stock if the share price rises to $10 per share and will continue to buy $100 worth of stock even when the price falls to $5 per share. This concept is remarkably simple, every investment professional speaks to their clients about this approach and almost every client concludes that this process is so simple that they can follow it for themselves without the need for an investment advisor. The reality is that very few investors maintain the discipline that is required for dollar cost averaging and few take the time to understand why.
Here again the counterfactuals come into play as investors are less likely to add to a holding whose price has gone up. The reason is due to the “regret” that comes from not buying more when the stock was cheaper. Having missed out the tendency is to ignore the “winner” because these stocks equate to the “silver medal.” The investor seeking to practice dollar cost averaging is more likely to pile into the stock that has fallen in price. This “loser” creates another counterfactual thought process that seeks to offset the “pain” of losing. It is the “bronze medal” effect. The investor would rationalise that if they buy more of the losing stock now then if the price goes up they can recoup their current losses and then some. The end result is that instead of consistently purchasing $100 worth of stock every month the investor’s actions will be skewed towards buying less when the stock price is rising and more when the stock price is falling. This downward price bias means that the investor is more likely to make purchases at increasingly lower prices thus creating a higher break even price as the losses on the stock mount. Continuously buying shares when the stock price is falling is often referred to as “trying to catch a falling knife.” If you ever attempted to do that in real life you should appreciate that there is a better than average risk of being cut in the process.
The emotional baggage associated with the investment decision will often lead the investor to conclude that dollar cost averaging does not work and investing on the whole is too much of a risky process. The perceived safety (and feeling of contentment) of a bank deposit awaits even though one is unlikely to achieve their investment objectives with a portfolio that consists entirely of such low-risk investments. The reality is that investors would be no better off giving preference to losers over winners all other things being equal. Staying the course regardless of the market circumstances is often the key to a successful investment outcome. Investors need to be aware that counterfactual thinking can negatively impact your investment performance. Recognise the reality that the second place finisher can be made to feel worse than the third place purely on the basis of “what if” and “if only”. The emotions become clouded when you invest your money for yourself. Your investment adviser is the person who has to keep the counterfactual at bay by focusing on what is factual.
Ian Narine is a broker registered with the SEC.
By Ian Narine
Source: www.guardian.co.tt