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?
5 thoughts on “Are your finances suffering from the Behavioral Finance Error of Disposition Effect? (blog by DH)”
I recently rolled my 401(k) into my IRA and the numbers started over. At first they were hanging around zero change so were red one day and green the next. Since it was a new account, I had the urge to look at it each day to see what was happening. Before the move I looked at it once a year. Suddenly I was looking daily and the red I felt in the pit of my stomach. I guess I’ll get over it. No I know it’s even got a name.
Dr. Cory S. Fawcett
Prescription for Financial Success
Hi Dr. Fawcett, Thanks for stopping by. Funny how the color of numbers affects how we’re feeling about our finances! Take care, BC
I’ve been studying the neuroscience of risk management. It turns out there are 2 different centers one for buy and one for sell. It’s not quite that clean but but bear with me. Buying is associated with the Nucleus Accumbens in the basal ganglia and the neurotransmitter dopamine. Dopamine sensitizes the NA to reward and further dopamine results in something of a positive feed back loop. It also may turn off risk averse behavior. Alcoholics are generally perfectly aware they are going 100mph, they just don’t care. Risk aversion OTOH seems to be related to the anterior Insula cortex which overlays the hippocampus (associated with memory). Risk aversion therefore may live in what I call the seat of wisdom, the place where sub-cortical risk analysis happens. Both of these seem to be older structures than the cortex and likely have considerable evolutionary survival value. I read one study where risk averse choices outweighed risky choices 4 to 1, implying a considerable bias toward risk aversion. This makes perfect sense when considering the irrational “sell low” behavior associated with a crash. The correct behavior is to not sell, not buy, but wait. In a crash selling “feels” like risk aversion, buying “feels” dopaminey good. Further more buying turns off risk aversion leading to buying. Selling (risk aversion) has a 4:1 bias so in some respect you are wired to sell at the wrong time. All of this happens at a sub-cortical non rational level unless you have taken steps to belay the inevitable wrong choice.
Consider what this means in the face of artificial intelligence. There is no biologic wetware programmed to make the wrong choice in an AI. AI’s work on probability functions predicting the most probable future, and learning and honing the prediction (reducing risk) as the process progresses. An AI wins by employing a 51% or better correct guess on the future and a whole lot of transactions. By then the wetware is cashed out of the game.
Thanks for stopping by Gasem! Lots of interesting info to dig into in your comment! Thanks again.