Prospecting investments

Why do investors tend to hold on to ineffective investments longer than they do to successful ones? Economists Mr Daniel Kahneman and Mr Amos Tversky, Nobel Prize winners think it may have something to do with the way investors look at losses and gains.

THE GROUNDWORK

Mr Kahneman and Mr Tversky's most popular study involves presenting two groups a problem with an identical outcome which involves only 200 people of 600 surviving after a disease outbreak. The group was presented with the following options: Programme A will result in 200 people being saved. Programme B will result in a 1/3rd chance everyone will be saved and 2/3rd chance no people will be saved. 72 per cent of the group went with Programme A.

The group was presented with two more scenarios: Programme C will result in 400 people dying. Programme D could result in 1/3rd chance no one will die, and a 2/3rd chance no one will be saved. 78 per cent of the Group went with Programme D.

Framing bias

Despite the identical outcomes, when presented as number of people saved versus dying, the group overwhelmingly voted for a riskier strategy in the latter scenario. This tendency to make different decisions due to a little tweak in presentation is called framing bias. A research study by Odean and Barber analysed the mutual fund buying and selling patterns of 30,000 households.

They found that people tend to rush into buying mutual funds which have performed admirably in recent times. Thus over half the purchase decisions between 1990 and 1996 were in funds which ranked in the top quintile in the last one year.

Basically we tend to extrapolate one year performance into possible performance during our entire holding period. This bias creeps into our sell decisions as well with nearly 40 per cent of all sales occurring in funds that rank in the top quintile of past annual returns. Worse yet, less than 15 per cent of the sales were of funds that ranked in the bottom quintile.

BETTER FRAMING

Investors, according to the study, were twice more likely to sell a winning fund than a losing one. The reluctance to shed a bad investment is likely to hurt overall returns. However, investors tend to hold on to these lemons harbouring hopes of a ‘strong comeback'.

That holding on to losing investments is a bad idea is neither novel nor counter-intuitive. A bad investment needs to produce remarkable performance to recoup your capital and then produce returns.

Worse, you could throw good money after bad investments in the hope of averaging out of trouble. The fear of a loss could also lead to rather skewed portfolio with investors loading up on bonds and real estate excluding stocks completely!

Fighting the tendency starts with more informed decision making at the point of picking your investment.

Ask yourself is that an investment which I will have the stomach and conviction to hold if it is down by 50 per cent. At that point if you decide to throw more money at the investment, it is important to look at the asset with a clean slate, free of the baggage you acquired when you put your hopes and capital in it the first time.

Map out your investment goals and decisions long before you actually have to make them. A stock, regardless of how attractive it looks, has no place in your portfolio if you run the risk of holding too much equity and less of bonds, gold or other assets. If you're so convinced that you need it, decide which of your current stocks or mutual funds belong in the bin.

When markets go into freefall mode, ask yourself is every stock or fund I own really worth this much. Don't sell because everyone is dumping. Sell because you are convinced there are cheaper assets worth making a worthwhile switch to.

COMMENT NOW