Capital Perspectives: Loss aversion revisited

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“More money has probably been lost by investors holding a stock they really did not want until they could ‘at least come out even’ than from any other single reason. If to these actual losses are added the profits that might have been made through the proper reinvestment of these funds if such reinvestment had been made when the mistake was first realized, the cost of self-indulgence becomes truly tremendous.”

– Philip A. Fisher, “Common Stock and Uncommon Profits” (1958)

Longtime readers know that we regularly interweave behavioral finance observations into this capital markets-focused column because overcoming or succumbing to our psychological tendencies can have as much to do with investment success, or the lack thereof, as does competent fundamental analysis. We have also written explicitly on several psychological tendencies. First, excessive self-regard, over-optimism and availability misweighing were highlighted through the lens of Charlie Munger’s The Psychology of Human Misjudgment. Munger is vice chairman of Berkshire Hathaway and longtime business partner of Warren Buffett. Later work discussed how anchoring, overconfidence, endowment effects and loss aversion can be harmful to investors’ financial health.

Today we delve further into loss aversion, perhaps the most destructive psychological tendency as it pertains to prudent investment. In a Dec. 3, 2020 newsletter DataTrek’s (datatrekresearch.com) Nick Colas provided a summary of a recent National Bureau of Economic Research (NBER) paper entitled “We are all Behavioral, More or Less: A Taxonomy of Consumer Decision Making” by Victor Stango (UC-Davis) and Jonathan Zinman (Dartmouth). The full paper can be found at www.nber.org/system/files/working_papers/w28138/w28138.pdf.

An important takeaway for readers of The Journal Record from this paper is that cognitive ability was found to correlate strongly with loss aversion bias. Although not the subject of this column (perhaps in the future) it is also worth noting that the other of the 17 decision-making biases examined showing a positive correlation to cognitive ability was ambiguity bias, which Mr. Colas described as “avoiding logical choices simply from a perceived lack of information.” Said another way, analysis paralysis.

In Mr. Colas’ words, “Behavioral economics is very good at detailing our mental deficiencies, but the only remedy this discipline seems to have is “OK, screw-up … Don’t do that again”. That’s fine as far as it goes. But ‘don’t be human’ has serious practical limitations.” I could not agree more. Therefore, the most efficient remedy for the negative impact these biases can have on our decision-making is likely not to overcome evolution by coaching these biases out of ourselves, but to acknowledge their presence and devise processes designed to neuter them. While philosophies can be adopted in the abstract, the specific processes adopted must be customized to the individual given we all have a unique psychological makeup.

Regarding our approach to the investment problem posed by loss aversion, once holders of a company, we monitor its fundamental progress and update our estimate of intrinsic business value accordingly. Regarding our sell discipline, we become willing to part ways with a holding upon the margin of safety (difference between estimated value and price) being meaningfully (everyone will have their own opinion about what “meaningful” means) reduced or eliminated. If all goes as planned, the margin of safety will be mostly reduced by price gains. However, margins of safety can also be reduced by deterioration in intrinsic business value, and in those hopefully seldom instances, selling at a loss would be rational. The point is that the decision to hold or sell a stock one owns should be based on what it is currently worth, not what one formerly paid.

Chas Craig is president of Meliora Capital in Tulsa (www.melcapital.com).

This column has been prepared by an employee of Meliora Capital, LLC. This column is for information and illustrative purposes only. It is not, and should not be regarded as investment advice or as a recommendation regarding any security mentioned herein. Opinions expressed herein are current opinions as of the date appearing in this material only and are subject to change without notice. Reasonable parties may disagree about the opinions expressed herein. The representations made in this column are based upon publicly available information and assumptions about future economic variables which may or may not be reflective of actual occurrences. Meliora Capital, LLC its employees or affiliates may have an economic interest in the securities identified herein.

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