Case Example: Behavioral Finance Biases In Stock Picking
For an audio version of this post, please click on the speaker icon (top left).
Before I immersed myself in the FIRE/financial online community (as late as 2011), I had absolutely no clue how to invest.
The only real investing experience I had was in a ROTH IRA I started in my residency.
It was through that process that I had my first interaction with a financial planner whom I later found out was less than ideal as he had promptly placed me in a front load, high expense ratio, mutual fund.
Several years later, with only basic investing skills at my disposal, I thought I would try to dip my toes in the market on my own.
I opened a brokerage account (Scottrade) and was immediately subjected to a cornucopia of stocks to choose from.
I had no idea what P/E ratios were.
Had no clue about how to utilize moving averages to determine if a stock was going in the right direction or not.
Yup, I was pretty much Bambi standing with wobbly legs in the midst of an investment forest.
Why did I shun getting professional help this time?
Behavioral Finance concept demonstrated: Experiential bias.
Having a bad experience with my one and only financial advisor likely guided me down the path of trying to do it on my own, even though I was financially illiterate at this point.
So what did this fledgling investor do?
Why use name recognition of course!
It is pretty sad to admit it, but that is exactly what I did.
I had no clue if a company was a good investment going forward or not, but if I recognized the name, it was pushed into the final round for selection.
I can’t remember exactly all the stocks I chose, but I know I did purchase Amazon, Caterpillar, Berkshire B, Wells Fargo, Apple, and even Facebook when its IPO launched.
Behavioral Finance concept demonstrated: Familiarity bias.
I also often participated in stock trading, selling and buying stocks on whims (at $7 a trade), something I had no business doing.
Through sheer dumb/beginner’s luck, a lot of these picks ended up being “winners” most notably my exposure to Amazon stock.
“Hey I must be pretty good at this!”
I just happened to be investing in the very early stages of the longest bull run in the history of the stock market.
It certainly was not skill on my part, but essentially due to the booming economy.
Behavioral Finance concept demonstrated: Overconfidence and Self Attribution Bias.
I picked up Amazon I believe for just under $200/share.
When I finally “saw the light,” switched to my brokerage at Vanguard, and converted everything into index funds, I ended up selling Amazon for around $530/share.
This certainly gave me a healthy profit but, because of the “retrospectoscope,” I contracted “What If Syndrome.”
As you may very well know, Amazon has continued to skyrocket (at the time of this writing each Amazon share is worth north of $1900).
Making 2.5x my original investment should have made me feel fulfilled.
But with hindsight helping me, 8x gains is even better, right?
And that is precisely the point of some of the psychological factors that plague individual stock investors.
Very rarely can you look back and feel like you did 2 transactions (the buying and the selling) at exactly the right time.
And even if you do incredibly well by selling a stock, like I did with my Amazon stock, you still feel unfulfilled when you later find out that the stock climbed even higher.
History repeats itself. The unlearned lesson.
After my financial awakening I was positioned entirely in index funds.
No issues whatsoever trying to time an individual stock.
No wasted time trying to pay attention to how that company was doing, what its earnings was, etc.
But around the end of 2015, and coinciding with the purchase of my Tesla Model S, I decided to purchase some Tesla stock at a $200 share price.
It was funny because of the rationale I used for buying this stock in the first place.
I absolutely loved my car (best automobile I have ever purchased and even 4 years and 100k miles later it still brings a smile to my face).
So I thought I would “support Tesla” and buy Tesla stock.
In a comment on the White Coat Investor website, I gave this as my reason for buying this particular stock.
None other than Jim Dahle, the White Coat Investor himself, casually remarked, “Oh, did you buy Tesla stock during its IPO?”
I instantly knew the message he was trying to convey.
Unless you buy the stock directly when it is offered to the public for the first time by the company, you are not supporting that company.
The majority of the stocks are on the secondary market and thus have no financial bearing on the original issuing company.
So my buying Tesla stock years after the IPO was not a sign of solidarity between me and Tesla like I originally thought.
The roller coaster.
For those that happen to follow Tesla, both the company and the stock, the following will not come as a surprise.
I would say that my ownership of Tesla stock was quite volatile.
There would be periods of incredible gains and then, shortly after, incredible losses (Tesla is near the top of shorted stocks).
I remember that Elon once made an announcement on Twitter that shot Tesla stock up (over $370/share if I remember correctly):
[By the way that was one expensive tweet, as Elon later found out, because of fines from the SEC.]
Because of greed, as I thought the stock would rise to the $420 mark that Elon hinted, I remained on the sidelines and held on for dear life.
Of course the stock did not continue its upward trajectory and actually started to fall precipitously, bottoming out at around $177 share.
As I saw thousands of dollars evaporate, there was a temptation to sell and cut bait.
Behavioral Finance concept demonstrated: Loss aversion bias.
But I persevered and held on to my Tesla stock, vowing that if it ever breached the $370/share barrier again, I would sell.
There have been previous psychology experiments demonstrating how a subject views a monetary reward depends on the sequence of events that occur before it.
How would you feel about ending up with $10 in the following situation:
Scenario A: Won $10 and walk away.
Scenario B: Won $1000 but subsequently lost $990 and walk away with $10.
Scenario B is a lot more painful than A even though you end up with the same amount, right?
For me scenario A would allow me to focus on the winning component and thus let me have a feeling of satisfaction.
Scenario B, on the other hand, would have me dwelling/fixated more on the $990 loss.
Scenario B was exactly where I was with my Tesla shares, now sitting at the $177 mark.
I mentally anchored on the amount of money “I would have gotten” had I sold at the “correct time.”
Stepping off the roller coaster.
A little over a year and half later Tesla stock began to climb quite remarkably and shot through the trigger point I wanted to sell my shares at (I sold my entire position for a little over $376/share), and I locked in some very nice gains.
So why am I not throwing confetti and celebrating with this clear win on a stock that I originally got into under the wrong pretense?
Because, as of this writing, Tesla shares continue to rocket upwards (recent high of $969/share).
Rather than celebrate an over a $176/share gain, I have been dwelling on the what could have been if I had just held on to the shares for a month or so longer.
I am thus fixated on the almost $600 “imagined loss” per share for selling “too early.”
This translated into leaving almost $30k on the table.
[To add salt into the wound, my entire position of Tesla was in my ROTH IRA which meant that there would be no capital gains tax on any of the profits.]
It is another example of following victim to the “What If Syndrome.”
Behavioral Finance concept demonstrated: Disposition bias.
With index funds, the above psychology behaviors are either eliminated or drastically reduced, thereby giving an additional non-monetary added value in the form of peace of mind.
I also like to point out that even though I have a degree in Psychology (and Biology) and have prided myself on vastly improving my financial knowledge, I am still not immune to these behavioral finance traps.
If you are in search of financial help, please consider enlisting the service of any of the sponsors of this blog who I feel are part of the “good guys and gals of finance.”
Even a steadfast DIY’er can sometimes gain benefit from the occasional professional input.
NOTE: The website XRAYVSN contains affiliate links and thus receives compensation whenever a purchase through these links is made (at no further cost to you). As an Amazon Associate I earn from qualifying purchases. Although these proceeds help keep this site going they do not have any bearing on the reviews of any products I endorse which are from my own honest experiences. Thank you- XRAYVSN