Are your finances suffering from the Behavioral Finance Error of Disposition Effect? (blog by DH)
Behavioral finance is a growing field with bright minds uncovering irrational decisions humans make. Many errors can be avoided, we just need to be consciously aware of these possible traps.
According to Terrance Odean*, investors usually sell stocks that have gone up and hold onto stocks that have gone down. This is known as the “disposition effect.” Further studies show shares sold tend to keep going up and stocks held continue to drop. This alone leads to most investors getting a lower return on their investments.
If this is done in a taxable account, the results would be even worse as people would miss out on the tax strategy of Tax Loss Harvesting—and even more so if they regularly donate appreciated stock to charity.
Awareness of a subtle change in technology will improve your investment return with near certainty. It has to do with the behavioral finance error of “disposition effect” and the way data is displayed.
This technology change is how brokerage websites display holdings. What is now commonly included on the display is the % total change (gain or loss). The interesting thing is the numbers are now color coded so gains are typically in green and losses are in red. I did not realize how this seemingly trivial change has real consequences.
Even though I think of myself as analytical/rational, I realized I wanted my numbers in green and did not like seeing my numbers in red.
At one firm we have a Taxable brokerage account. I love the colored numbers because at a glance I can see if I have a loss. If the loss becomes large enough (predetermined 5% loss), it is my duty to sell that security and buy something similar. Even though I’m “losing” money, it still “feels” good because—poof—the red is now gone! Doing this also enhances my returns because I can stay in the market and save some money by tax loss harvesting.
At another firm, I have my 401k from my employer. A few years ago, there was a change in the plan. Although nothing was sold, all the historical data was lost, and the purchase price/dates were changed from the actual date of purchase to the date of changeover.
During this time, the market had risen overall, and there were a lot of green numbers. After the change, the green numbers (% gain) were significantly smaller, or even worse, they became red! This bothered me a lot.
Intellectually, I knew nothing had changed, but darn it—I didn’t like seeing red numbers. And yes, I had kept my own spreadsheet with totals from all accounts. But even so, when I looked at the holdings page with all those new red numbers, I felt annoyed.
Going forward: in this tax-deferred account, whenever I have to make a change for the good of our total portfolio, but a move nonetheless that hurts the “green” numbers, I don’t like to do it.
Another surprising thing about how strong these colors “pull” at my decisions is that no one sees them but me. My wife doesn’t like to view the separate accounts, but rather the totals in aggregate. We don’t have an advisor who sees this stuff. Why do I care about these colored numbers when they are essentially meaningless in a tax-deferred account and can hurt my returns? It is because I am human.
What is my strategy to deal with this? In a taxable account, I fully embrace it. In deferred accounts, I think the key is to be aware of this trap. I tell myself I’m doing the right thing, hold my nose, and make the trade—ignoring the siren call of the red numbers. I also limit how often I view this account. I wish there were a way to turn off the color-coding, or completely remove % gain—but still be able to see this if I chose to search for it.
So there you have it. Something as simple as red and green colors can affect our decisions.
If you’d like to read more about Behavioral Finance, here are 2 outstanding books:
*Why Smart People Make Big Money Mistakes and How to Correct Them , Belsky (pg. 61-64)
Anyone else struggle with this or have other solutions that work for them?