Risk-Related Biases
Loss Aversion:
  • Stephen W. Boesel was the director of the $11 billion T. Rowe Price Capital Appreciation Fund until mid-2006. The fund has a 16 year winning streak (as of mid-2007), and it is the only equity fund to report 16 positive years in a row. Boesel summarized his money management strategy for the fund in the Wall Street Journal as follows: "We win by not losing." Notice that Boesel doesn't try to find winners, rather, he avoids losers. In order to "not lose," the fund cuts its losers short (and lets its winners run).
  • "Cut your losers short" is a Wall Street aphorism that encourages investors to do the opposite of an innate tendency. Most investors are inclined to hold losing positions too long. This is the single most common and costly mistake investors make.
  • Most amateur investors either avoid thinking about losing positions or they hope for a "comeback" so they can exit the investment at "break-even." Ironically, if an investor is bailed out by the market, they tend not to learn from their mistake, leaving them more vulnerable to later losses.
  • Most "Rogue Traders," including Nick Leeson (Barings) and Toshihide Iguchi (Daiwa Bank), who both lost over $1 billion, ended up with huge losses because they could not muster the courage to bail out of losing positions in the beginning, and then they developed illegal strategies for hiding their snowballing losses.
  • One of the three tenets of the 2002 Nobel-prize winning theory of economic decision-making called "prospect theory" is that people avoid taking losses, even when that avoidance will likely lead to larger losses later. For example, when faced with the choice between (1) losing a definite amount of money, or (2) gambling on a "come-back," most people prefer to take the gamble. Note that most people will choose the gamble even when the expected value of the gamble is more than twice as severe as the definite loss.
  • "Even being right 3 or 4 times out of 10 should yield a person a fortune if he has the sense to cut his losses quickly on the ventures where he has been wrong."
  • ~Bernard Baruch, Financier
  • After experiencing a recent loss, most investors will become more loss averse. Losses of any kind have this effect - the death of a loved one, divorce, illnesses, accidents, work-related losses, and financial losses - all increase this propensity.
  • Most people suffer from loss aversion, though it is stronger in high scorers than in low scorers.
The result of loss aversion is "throwing good money after bad." If you are a high scorer, you are more likely to hold onto losing investments for longer than originally planned. The following recommendations assume that you are an active investor:
  1. Ask yourself, "All things being equal, would I enter this position today?" If your answer is "no," then place it on your sell list.
  2. When in a losing position, beware of thinking, "I'll just wait and see what happens." Notice any rationalizations or excuses you make in order to hold a losing position longer.
  3. If you already have a track record of holding losers too long, and you have little experience, beware of purchasing naked options and shorting.
  4. 4. If you have the technology, keep track of your Win/Loss size ratio. Investors can discover if they are holding losing investments too long by keeping track of the size of their winning and losing investments. The ratio should be more than 1 (more money in open winners than open losers). One can also monitor the length of time they hold your losing versus winning investments to diagnose this problem.
  1. Remember that even though you are a low scorer, you are still susceptible to holding onto losing positions too long, especially after recent or large losses.
  2. As always, be sure to practice risk management. If you don't have a defined money management system, then be sure to look into this.
Emotional Vulnerability: Your result is .

  • "Success in investing doesn't correlate with I.Q. once you're above the level of 25. Once you have ordinary intelligence, what you need is the temperament to control the urges that get other people into trouble in investing.
  • ~ Warren Buffett
  • The Buffett quote above indicates that the ability to manage your impulses, particularly those stemming from emotion, leads to greater investment success than intelligence alone.
  • If you are a high scorer on emotional vulnerability, you are likely to experience panic, confusion, and helplessness when under pressure or experiencing stress. If you are a low scorer, you feel more poised, confident, and clear-thinking during stressful times.
  • "We simply attempt to be fearful when others are greedy and to be greedy only when others are fearful."
  • ~ Warren Buffett
  • Buffet can maintain a long-term perspective during emotional periods in the markets. As a result, he can go against the prevailing market sentiment (and thus take advantage of mis-pricings). Such emotional stability is essential in order to find bargains during periods of market volatility.
  1. Practice self-awareness. It is important for high-scorers to know when they are in a negative emotional state — without awareness, they cannot take action to halt the destructive effects of negative emotions or take advantage of negativity in the markets. Meditation and yoga help practitioners identify and objectively reflect on reactive emotional states. Vigorous exercise can also increase your stress tolerance.
  2. Check your investment prices as infrequently as possible. Checking position progress too frequently stimulates emotional reactions without giving useful information.
  3. Stick to a defined money management plan. Know your entry and exit points in advance. Have clearly defined buy and sell signals. (These concepts are easy to acknowledge, but during periods of market volatility you will have trouble following them - know this).
  4. Avoid short-term trading if possible. You are vulnerable to emotional burn-out from rapid trading. You will probably benefit from using an investment style that fits your more stress-sensitive personality.
  1. 1. You are probably more calm than most during market volatility. Nonetheless, become aware of the triggers for negative emotional states during investing. If emotions are a problem for you, then see the recommendations above and consider whether you can adapt your investing style to accommodate.
Risk Aversion

Loss Aversion: Your result is .
"You get recessions, you have stock market declines. If you don't understand that's going to happen, then you're not ready, you won't do well in the markets."
~ Peter Lynch
  • Risk aversion refers to an excessive fear of risk-taking. Risk aversion can trigger investor hesitation, indecision, and "analysis paralysis." Many investors with high risk aversion experience difficulty "pulling the trigger" in volatile markets.
  • Some investors experience risk aversion as "waiting for confirmation." Unfortunately, waiting for expected price movement erodes profits. Indulging the inclination to delay can precede impulsive entries and exits later on.
  • When investing without adequate due diligence, risk aversion is appropriate. Investors should do background research to gain confidence. Sometimes losses are due to random events, and in those cases it is helpful to understand the laws of probability and the inevitability of draw-downs (an understanding derived from having a solid investment philosophy).
  1. High risk aversion can be managed in several ways. Amateur investors who have high risk aversion should probably entrust their money to a trusted professional (such as a financial advisor). Most advisors will take an appropriate amount of risk for the long-term growth of your portfolio, and high scorers will not have to worry about the best course of action to take with their assets.
  2. As with many of the volatility-sensitive profiles above, risk averse investors should check the value of their portfolios as infrequently as possible.
  3. Confidence can be built with market experience, gradual exposure to market risk, education, and the constructive challenging of one's fears.
  1. Very Low scorers should beware of taking excessive risk. But in combination with adequate self-discipline, education, historical knowledge, experience, and preparation, a low score on risk aversion is usually beneficial for investors.
Cutting Winners Short: Your result is .

"Selling companies that are doing well and purchasing ones that are faring poorly is like watering the weeds and cutting the flowers."
~ Peter Lynch, Fidelity Investments
"Our favorite holding period is forever."
~ Warren Buffett
  • J.R. Simplot is an 8th grade drop-out and a self-made multi-billionaire. He made his fortune through saavy investments in potato farming and french fry production. Currently he owns the largest ranch in the United States, the ZX Ranch in southern Oregon. His ranch is larger than the state of Delaware. Despite his tremendous wealth, Simplot is a modest man. He describes his accumulation of wealth to Eric Schlosser (author of Fast Food Nation):
  • "Hell, fellow, I'm just an old farmer got some luck," Simplot said, when I asked about the keys to his success. "The only thing I did smart, and just remember this - ninety-nine percent of people would have sold out when they got their first twenty-five or thirty million. I didn't sell out. I just hung on." [bold added]
  • In general, most people sell their winning investments too soon ("cutting winners short"). According to some experts, selling winning investments too soon is a result of "seeking pride." Others believe that cutting winners short is related to obsessiveness. The truth is a mix of both. Everyone is susceptible to this bias to some extent.
  • If you are a HIGH SCORER or are guilty of cutting your winners short, you should:
    1. When you feel yourself becoming worried about a winning position, don't impulsively sell. Instead re-evaluate your selling criteria. Did the investment meet your profit target? Has something fundamental changed about the security that indicates you should sell now?
    2. Be prepared for your short-term winners to give back some of their gains. Reversals are very common after a rapid, large price rise, especially when it is unsupported by news.