Mark Riepe: Pope Gregory I served as head of the Roman Catholic Church in the years 590 to 604. He was pretty successful as popes go and is referred to by some as Saint Gregory the Great.
You may be familiar with one of his accomplishments: the codification of what is now called the Seven Deadly Sins.
The name says it all. This is a list of sins that are considered especially pernicious. For those who don’t have their list handy, they are, in alphabetical order:
- Sloth, and
Gregory didn’t come up with these all on his own. He started from something called the “Eight Evil Thoughts.” This list was created by a 4th-century monk who was born in what is now Turkey. The monk’s name was Evagrius Ponticus.
I’m interested in Evagrius because when he was writing in the original Greek, he didn’t use the word for sin. Instead he used the word for thought. This was a deliberate choice.
He wrote, “It is not in our power to determine whether we are disturbed by these thoughts.” I’m no theologian, but I think what he’s getting at is that the word sin implies an active choice to do something wrong. In other words, we commit a sin. His view was that these thoughts are present in everyone, and it is up to us to decide whether we act upon them.
I’m Mark Riepe, and this is Financial Decoder, an original podcast from Charles Schwab.
It’s a show where we study the cognitive and emotional biases that can influence your financial decisions. And we offer strategies designed to help you mitigate those biases and improve your financial life.
I like the way Evagrius thinks about his “Eight Evil Thoughts.” His description of them is true about virtually all of the heuristics and biases, both cognitive and emotional, that we’ve discussed in the 14 episodes of this show.
You can’t get away from these biases. They’re too ingrained in us. And while it is true that some studies show more experienced people are less susceptible to these biases, there are other studies that show awareness has minimal impact and experts in various fields are just as susceptible to them as the rest of us.
All is not lost, though. What you can do is create structures or guardrails around your decision making that keep you more or less on the correct path.
This episode is a little different from the ones we’ve done in the past. Instead of zooming in on one or two biases in detail, we’re going to run through a larger than normal list of biases that all have an impact when you’re making trading decisions and then focus more on techniques that can blunt the impact of those biases.
We’re focusing on trading because it’s a crucible of emotions and analysis. During volatile markets and periods of economic change it is common for regular investors to ask whether they should be more active with their portfolios.
That may make sense, but before you make that transition, you need to be aware of and comfortable with how the many biases and heuristics we’ve talked about manifest themselves I the context of individual stock trading.
Joining me now to discuss how biases can affect trading decisions is Randy Frederick. Randy is vice president of trading and derivatives with the Schwab Center for Financial Research. Thanks for being here, Randy.
Randy: Thanks for having me, Mark.
Mark: Traders are people, and because of that they’re susceptible to a wide variety of cognitive biases and psychological traps. Why don’t we go through a few of those, and tell me what strategies might be most effective in overcoming them. Let’s start with overconfidence.
Randy: Well as you know, Mark, I spend a lot of time traveling around the country speaking to our investors and active traders, and I do run into people occasionally that you could describe as overconfident. But trading is not an easy thing to do well. There’s just so much to learn, and many traders just don’t know how much they don’t know.
There’s an old expression that says, “Don’t confuse a bull market with trading skill.” As you know, the current bull market has been going on for well over 10 years, so it’s likely that there have been many investors who have had a lot of success but have never really lived through a bear market.
Mark: Randy, why don’t you give me an example of how this plays out in real life.
Randy: OK, let’s consider the technology sector. During this 10-year period, the tech sector has gone up over 400% compared to only about 300% for the S&P 500®, so it’s likely that some investors have earned that much or even more by buying and selling technology stocks.
But many tech stocks are high beta stocks—meaning they tend to go up faster than the market does, but they also tend to go down faster than the market does. During the Q4 2018 market correction, for example, when the S&P 500 fell just short of 20%, the tech sector was down over 24%.
When the next bear market comes along, buying tech stocks probably won’t just be a losing strategy; it might be a strategy that loses even more than the broader market. And many investors are unlikely to realize their strategy is no longer working until the losses really start to pile up.
Mark: One thing I mentioned in the introduction is that you should build in some controls or guardrails into your process to account for the fact that you can’t be expected to be completely rational at all times. Do you have any examples of that when it comes to trading and dealing with overconfidence?
Randy: I think there are two key ways for investors to deal with this issue. One: Limit active trading to no more than about 20% of your overall portfolio. It’s common to think of our clients as either investors or traders, but that’s far too simplistic. No one should be trading his/her entire portfolio. Everyone should be a long-term investor, but some of those investors also choose to be traders. And two: Within that 20% most people should limit each individual trade to no more than about 5%—that’s a loss that almost any investor can bounce back from. The goal with both of these limitations is to never be too concentrated in any one position or in any one trade. Because everyone makes a bad trade now and then, but it should never put your long-term portfolio at risk.
Mark: A couple of other biases we’ve covered on previous episodes are the sunk-cost fallacy and loss aversion. A lot of times traders don’t want to give up on a position because they feel like they’ve already invested so much time and energy analyzing the stock and if it doesn’t do well having to sell and realize a loss—that really hurts. How do you counteract that?
Randy: This is a really good one, Mark, and I’ve even found myself falling into this one from time to time. As you know, most investors buy a stock with the intention of eventually selling it at a profit at some point in the future. Unfortunately, not every stock they buy is going to go up. And while it is true that as long as the company doesn’t go completely bankrupt, they can essentially hold that stock forever; but that doesn’t mean they should. Every dollar spent on any investment has an opportunity cost—which basically means that money is not available to be used on another investment that might be much more profitable. An old adage among active traders is “Don’t let a losing short-term trade become a losing long-term investment.”
Mark: Are there any times where adding more to a losing position actually does make sense, though? I’ve heard plenty of people say (and I think I’ve said it myself a few times) that if a stock makes sense to buy at $100 per share it makes even more sense to buy it at $90 per share.
Randy: I’ve seen examples where a short-term trade doesn’t work out so well, so a trader doubles down and buys more. This can be a good strategy but only—and I really want to emphasize only—if his/her opinion about the stock hasn’t changed. No one gets it right every time, but if all the reasons for why you bought the stock in the first place are still valid, buying more can be an effective way to lower your overall cost basis. But if the reason the stock went down is because of new unfavorable information that wasn’t available when you bought it initially, then buying more is probably just throwing good money after bad.
Mark: So that’s good advice, but under real-world conditions, getting anyone to look objectively at a position, that can be really tough. What questions should traders ask of themselves to avoid these traps?
Randy: Well, a simple rule of thumb that I encourage all traders to follow—and this is true whether they’re considering cutting losses on the original position or adding to it—is “If they didn’t already own it right now, would they buy it?” If the answer is no, then it probably makes sense to just sell it, take the loss and move on. If the answer is yes, then the decision whether to simply hold the original position or add to it should be based on what percentage of the portfolio the current position represents and what percentage it will represent if they buy more.
Mark: Randy, there’s a concept known as prospect theory, and one implication of it is that when traders are behind, they are prone to start taking risks that they wouldn’t take if they were ahead. It kind of reminds me of the phrase “When you’re in a hole and trying to get out, the first step is to stop digging.” Does this ring true based on your experiences, and again, if so, what do you do about it?
Randy: Boy, it sure does, Mark, and it’s one of the key principles that we encourage traders to follow when market volatility is on the rise. Most traders think they have a high tolerance for risk—until they encounter a bear market.
As I know you’ve talked about in the past, the pain of a loss hurts much more than the joy of a gain, and after many years traveling around speaking to our clients, I’m convinced that most traders’ risk tolerance is much lower than they think.
Historically, long-term investing in equities has generally paid off well, but when investors encounter a brutal bear market like the one we experienced during the 2007-2009 financial crisis, it’s really hard to focus on the long term and be confident that it will all come back again. I get it. Sure, it’s always happened in the past, but we can never be completely sure that it will happen again.
And if that wasn’t stressful enough, as you pointed out, some traders exacerbate the issue by taking on excessive risk to try to recover those losses, when usually that’s exactly the opposite of what they should be doing. Even if they have a good understanding of their own capacity to withstand losses, they still shouldn’t take actions that will make the problem worse. There’s just no two ways about it—trading profitably during times of high volatility is just harder, so their position size should be smaller, not larger.
Mark: Yeah, I agree that volatile markets may well exacerbate some of the tendencies that we’ve been discussing. Given that, how should traders change their approach during volatile markets?
Randy: One habit I encourage in all markets, but especially in more volatile markets, is called scaling. Scaling in and out of positions by buying and selling in smaller increments than usual is a good way to reduce risk.
Mark: That’s a great idea. Can you give our listeners a numerical example of how this works?
Randy: Sure. For example, let’s assume you’d like to own 1,000 shares of XYZ. Don’t buy 1,000 shares; buy just 200 shares instead. Then watch it for a while, and if the price drops, buy another 200, and so on, until you’ve eventually scaled into the full 1,000 shares.
So consider some of these benefits of using this approach:
- When you scale in, you don’t have to try to buy at the exact bottom; you just have to get somewhere reasonably close.
- Scaling in can reduce your overall cost basis if you buy it as the price is falling.
- And if your opinion changes because the stock stops falling, or if the stock starts falling too quickly, then you can always stop buying before you end up with the full position.
- And if you do continue to buy as the price falls until you acquire the entire 1,000 shares, once the price starts to go back up, you’ll reach profitability much sooner.
Mark: That’s a great example of using scaling to buy into a position. I assume scaling is applicable both when buying and selling, so give me an example of how it works when selling.
Randy: That’s right. So if you have 1,000 shares that you’d like to sell, don’t sell the full 1,000 shares; instead, consider selling just 200 shares. And then watch it for a while, and if the price rises, you can sell another 200, and so on, until you’ve eventually scaled out of the full 1,000 shares.
Similar to the scaling-in strategy:
- When you scale out, you don’t have to try to sell at the exact top; you just have to get somewhere reasonably close.
- Scaling out can increase your overall profit if you sell as the price keeps rising.
- If your opinion changes because the stock stops rising, or if the stock starts rising too quickly, then you can always stop selling before you end up selling the whole position.
- Essentially, if you sell some and the price goes up, you’ll be glad you didn’t sell it all. If you sell some and the price goes down, you’ll be glad you sold some before the price fell. Either way you’ll feel pretty good about the decision you made.
Mark: We kicked off this episode talking about the Seven Deadly Sins, and one of those is greed. You’ve warned traders in the past about not having an “all-or-nothing mindset.” What do you mean by that, and how does it help?
Randy: It’s never a bad idea to take some profits off the table. But I’ve run into so many traders over the years that get themselves into this all-or-nothing mindset. Selling and taking some profits is a good way to lock in gains and reduce overall risk. But keeping some of the position on also allows for participation in further upside. “All in” or “all out” is never a good idea, but during times of higher-than-average volatility, a slightly higher cash allocation can be prudent.
Mark: Randy, we’ve been talking about specific biases like feeling overconfident, being overly loss averse, and being overly aggressive when trying to get back to breakeven. There’s also a line of empirical work that looks at how emotional states are associated with trading success.
In one study a group of traders using their own money were tracked on a daily basis. Their actual performance was compared to their self-reported emotional state during the day. And there was a negative correlation between performance and the intensity of their emotion. In other words, the people who tended to have the bigger emotional swings, both positive and negative, tended to perform worse. What’s your reaction to that?
Randy: Emotions can be powerful things, Mark. In fact, there are many people who believe the stock market is essentially controlled by two emotions—fear and greed—but I don’t think investing has to be like that.
One thing you can do is just not take on any position that will create stress.
Mark: That’s really intriguing. Give me some examples of the types of positions that are inherently stress-inducing, and give me a quick definition of each one and why it is more likely to induce stress.
Randy: Sure, here are some examples:
- Concentrated positions in volatile stocks. This is the proverbial “putting all (or most) of your eggs in one basket. This never makes sense, and in a particularly volatile stock, it can cause wild swings in the value of your portfolio.
- Unhedged short positions. Short stock positions have unlimited upside risk, but that risk can be substantially reduced by using buy-stop orders and other protective strategies.
- How about positions that use most or all of your available margin buying power? Buying stocks on margin can be a good idea at times, but it’s never a good idea to borrow so much that a very small move against you results in a margin call.
- And finally, two or three times leveraged inverse ETFs and ETNs. These products are very complex—they’re really only intended for day traders, and they’re much more risky that most retail traders realize.
Mark: Let’s walk through a few of those to make sure listeners understand these types of positions. By short positions, you mean selling a stock that you don’t own in the hopes of buying it back later at a lower price. Is that right?
Randy: Yes, that’s what I’m talking about. Most people know that to make money in stocks you have to buy low and sell high. But it doesn’t have to happen in that order. You can actually sell high and then buy low, once the stock has dropped in price.
When you sell a stock before you buy it, it’s called a short sale. To do this, your broker has to be able to borrow the stock from someone else, but that’s not the risky part. The risky part is that unlike when you own a stock, which can only drop all the way to zero, when you are short a stock, it can go up to infinity … at least in theory. And having that much risk can be really stressful, especially when the market gets volatile.
Mark: Randy, you also mentioned ETFs and ETNs—those are exchange-traded funds and exchange-traded notes. We did a whole episode on ETFs last season, so people can go back and listen to that to get the basics. I think the point you’re raising, though, is that leveraged versions of ETFs are designed to have much bigger up and down swings, and that’s what creates the stress. Is that the gist of it?
Randy: Exactly. Leveraged products. And what many traders don’t understand is that the leverage resets each day, so many of these product dwindle in price over the long term. They’re really only appropriate for strategies that last a day or two.
This may sound a little strange, but let me give you an example I often use in my live client events. Suppose an ETF is supposed to move two times the underlying index each day. Let’s say the index is at 100 on day one. If it drops 10% on day two and then rises 10% on day three, the end result is you’re at 99 again, or a 1% loss. Likewise, if the index is at 100 on day one, and it rises 10% on day two, and then drops 10% on day three, the end result is also 99, or a 1% loss.
So the point here is that because of how these percentages and this leverage works, every down day results in a larger loss than the gain from every up day. And if it’s a three-times leveraged product, the effect is even worse.
Mark: In the introduction I talked about how a lot of the emotions that can get us into trouble are a fundamental part of being human. They’re part of who we are. Is that why dealing with emotions makes investing so hard at times?
Randy: I’ve always felt that one of the hardest parts of investing is that the right thing to do is often the exact opposite of what your emotions are telling you to do. When the market is down sharply, your gut often tells you to sell, and when it’s up sharply, your gut tells you to buy. But sell low/buy high is not how money is made in the market.
Mark: That’s a great point. And I’m sure you’ve seen plenty of real-world examples of when an investor knows on some intuitive level they shouldn’t sell, but they end up doing it anyway, simply because of their emotions.
Randy: I think one of the best examples of this was in late 2008. I was traveling around the branches just about every week giving presentations and trying to help reduce the level of panic that many investors were feeling. I can’t tell you how many times I was asked if I thought it was a good idea to just sell everything and get out of the market altogether. Many investors shared with me that they had lost 40, even 50% of the value of their portfolio, and they just couldn’t bear the thought of losing the rest. Logically, I have to think that they really didn’t think the S&P 500 was going to zero, but their emotions were so much in control that they just couldn’t break free. I always encouraged those investors to just hold on and don’t do anything, but I know some of them didn’t listen.
Of course we now know that the financial crisis bottomed in March of 2009, and the S&P 500 has gained over 300% in the last 10 years; that’s the longest bull market in history. And some of those investors probably missed out on part of that. An important point I emphasize at all of my branch events is that the average length of all the bear markets since World War II is only about 16 months (or less than a year and a half), but the average length of all the bull markets since World War II has been 62 months (or more than 5 years), so sometimes doing nothing is the best thing to do.
There aren’t many places in life where procrastination is rewarded. Fortunately, investing is one of those places where it can be.
Mark: All right, Randy, I have one more question. There are studies that looked at actual investor behavior and find that those people who trade individual stocks are sometimes reluctant to trade a stock if they’re previously traded that stock and the trade didn’t go their way. It’s as if they cross that trade off their list and they’ll never revisit it again. The question to you is, how do you learn from your experience and not become a prisoner of it?
Randy: This is a fascinating topic, Mark, and I think it’s worth discussing because it affects traders and investors alike. I’m going to call this avoidance trading, because I see it as very closely related to another irrational activity that’s known as revenge trading. Now revenge trading happens when traders experience a loss on a stock, and then they vow to get it back at all costs. I mean, they kind of view the situation as if the stock were a person who stole their money.
Of course the stock didn’t intentionally act against them; they simply had a losing trade. Obviously, revenge trading hurts the trader much more than the stock in question because it might cause them to double-down on a bad stock position when probably they shouldn’t own any at all.
Neither avoidance nor revenge trading is the right approach, so to answer your question of how do you learn from your experience and not become a prisoner of it, I think the key word is experience. The longer you invest, the more experience you have, the more times you’ll have gains and losses. And hopefully you’ll recognize that both are just part of what it is to be an investor.
I think it’s just human nature to seek out someone or something on which to blame our own failures, rather than admit that we made a mistake. But the fact is everyone—and I mean everyone—has losing trades. And once you stop viewing a losing trade as a mistake, but rather just a normal part of investing, I think you won’t need a place to place that blame any longer.
And if you still have a psychological bias against a particular stock, it’s not the end of the world. There are plenty of other fish in the sea—actually, about 4,000 of them.
Mark: Thanks for all this information, Randy. Really great insight, very helpful. Thank you.
Randy: You’re quite welcome, Mark. I enjoyed it.
Mark: In the Federalist Papers #51, James Madison wrote, “If men were angels, no government would be necessary.”
As the Eight Evil Thoughts and the Seven Deadly Sins remind us, we all are a bundle of emotions, mostly good ones but some bad ones. Since we can’t rely on ourselves to manage the bad ones, we put in structures to serve as a backstop.
Investing is similar. You can’t rely on yourself to never be swayed by emotions. But you can create rules and structures that inhibit you from making poor choices—choices that are driven by pure emotion and not rationality.
Of the biases we discussed with Randy, overconfidence might be the most prevalent. Randy mentioned several strategies for ring-fencing our own overconfident tendencies. Trading only a set portion of your portfolio, maybe 20% or less, can help limit some of the damage you can do, but also consider using a trading-plan worksheet to think as objectively as possible about your trading.
The sunk-cost fallacy and loss aversion are similar to one another.
The sunk-costs fallacy tells us to hang onto a position or an investment.
Loss aversion makes losing a dollar feel twice as bad as gaining a dollar—so consider using trailing stop orders to take that emotion out of the equation.
Don’t forget that when you place a stop order, you have to decide how many points or what percentage below the stock price to place the order.
Many traders have a standard policy that they use, such as 5% or 10% below the purchase price. For traders who determine the size of each trade based on the dollar amount invested, rather than the share quantity, a point value may be more effective than a percentage.
Some disciplined active traders follow a rule that no loss should exceed a certain percentage of the value of their total portfolio. For example, some traders might set this percentage at 1% or 3% of the value of their portfolio or whatever percentage they feel is appropriate.
Finally, the title of this episode is “Should You Be More Active With Your Portfolio.” It’s impossible to answer that with a definitive yes or no. It all depends on what you want to get from your investments and the time and effort you want to devote to it.
You can be successful no matter which path you choose. But the road to success is easier if you pick the path that matches with your goals and you’re aware of and protect against the psychological traps that are present on either path.
That’s it for Season 2 of Financial Decoder. We’re taking a short break over the summer, but we’ll be back with more episodes in September, so stay tuned and stay subscribed.
If you’re new to the show, you can go back and listen to previous episodes at schwab.com/financialdecoder.
Two of our most popular episodes were “How Can You Save More?” with Carrie Schwab-Pomerantz and “Should You Rethink the Risk in Your Portfolio?” with Tobin McDaniel. If you’re nearing retirement, check out “When Should You Take Social Security?” with Rob Williams. If you’re just getting started investing, I’d recommend listening to “How Can You Reach Your Financial Goals?” with Chris Thom.
If you’d like to learn more about some of the trading strategies Randy discussed, check out schwab.com/tradinginsights.
You can also learn a lot about buying and selling stocks by watching our experts each business day at schwab.com/livedaily.
Thanks for listening. As always, let us know how we’re doing by leaving a review on Apple Podcasts or your favorite listening app. It would be much appreciated.
For important disclosures and a transcript, see the show notes and schwab.com/financialdecoder.