Friday, 21 March 2014

How To Fool Yourself

Source

We are all a bundle of hundreds of hard-wired behavioural patterns that have successfully kept our genes alive since Adam underwent a bit of surgery. This means that our monkey brain decides to do many things without us really thinking about them: at best we rationalise an ex-post semi-logical explanation. I talk from experience.

Because we are generally unaware of there behavioural responses (or 'bias' to give them their more formal name), they are very powerful - and can be used against us quite successfully (think of any breed of salesman). At the very best, we can hope to recognise the patterns and adopt some kind of strategy to minimise their influence - because it's not like you can turn them off.
One of the strongest behavioural quirks in investing is 'loss aversion': being happier to risk a profit rather than an equivalent loss. I suffer from this but try to keep it under control through various strategies and investing 'rules'.

Sometimes that doesn't quite work. Take my holding of FirstGroup (LSE:FGP) the UK public transport operator, also big-ish in the US.  [Don't you just love the creative punctuation - I wonder how much it cost to lose a space and go from 'First Group' to FirstGroup]

Here is the story:
  • April 2010: big operation, attractive yield - buy @ 367p
  • Yield and share price plummet - oh dear, but keep holding on...
  • July 2013 (three years later!): situation improving - double up by buying @ 85p
  • March 2014: share price is around 138p

What can I learn from this?
  • First, this investor really doesn't like to sell his losers. Watching a falling price over three years doesn't look like much fun.
  • Second, FGP didn't go bust (yet) - if the price recovers to the point where the capital loss is wiped out, the overall cost will be the opportunity cost of lost income for a couple of years.
  • Third, the return on the July 2013 purchase is over 60%. Not enough to wipe out the loss of the previous poor purchase but still one of the best returns I have been able to hold onto without selling. Had it been a stand-alone purchase I would in all likelihood have cashed in my chips already,

For me, the interesting feature is that by doubling up in 2013, it seems to have dealt with two aspects of loss aversion at once:
  • as the share price rises, I feel less bad about the initial purchase decision (and the capital loss)
  • but because the total investment in FGP is still showing a capital loss, I don't feel the urge to grab an early profit from the 2013 purchase

So, who's fooling who(m)?




I am not a financial adviser and the information provided does not constitute financial advice. You should always do your own research on top of what you learn here to ensure that it's right for your specific circumstances.

10 comments:

  1. Hi,
    So at what point do you think its best to "cut your losses". 10% loss, 15%, 25%, 50% or just hang on? I don't like to lose money but a 10% loss is preferable to 20%.







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  2. As always a great post. I don't know if your saw it but horizon had an episode recently that looks into this topic. I definitely suffer from loss aversion. The problem is you think you learn from your mistakes yet usually the same happens time and time again.

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  3. Interesting post given my current dilemma.
    I have around £3500 invested in RSA with a price per share of 1.25.
    I currently have the capacity to invest the same amount again in them which by my sums will bring the price per share down to 1.06.
    I reckon there's a lot more chance of them getting to around 1.10 than 1.30 and am thinking of buying a bunch to drag my price per share down with a view to sell when they get closer to profit (depending on my bottle).
    What would you do? Or is it worth just cutting my losses and getting out? I'm currently £800 in the red on them....

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  4. What's your take on TLPR at the moment?

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    Replies
    1. Hi Anon

      Yes, they are on my radar: how did you know?

      Delete
    2. Hi,
      Looks like divi will be maintained; so good yield at the mo. However, price has weakened considerably of late. Court ruling imminent. Looks a good buying . Didn't you hold these last year?

      Delete
  5. Hi DIY,

    From what I could see, assuming you bought on April 9, till Sep 2011, you were about the same price and would have collected dividends like clockwork.

    That is when the rails started coming off, with a steep plunge in March 2012.

    If let us say, you had a stop loss of price - collected dividend less 5% (which is your yield target), you would have a stop loss of 3.14.

    The calculation is (3.67 entry - collected dividends of 0.14, 0.0712, 0.15 ) * 0.95.

    The moment that was breached in November 2011, you would have exited.

    My suggestion is that like you have a "Sell" indicator which flashes red when you collect 5 years dividend, you should have a "Sell" indicator which flashes when your capital is at risk.

    Ultimately, you can still decide to ignore the Capital risk "Sell" indicator, but at the very least it flashes it.

    I hope that you find this useful.

    Regards

    V

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    Replies
    1. Thanks V - very helpful! That is the one element in my investment rules I am missing at the moment, although it is fairly obvious now that you mention it. Food for thought.

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    2. Hi DIY,

      Here is the paper which outlines the ideal level.

      papers.ssrn.com/sol3/papers.cfm?abstract_id=2407199

      I think they have outlined a 10% level, though, that is up to you to change as you see fit

      Regards

      V

      Delete
  6. cashing in is all well and good but assumes you have a good place to reinvest. At the current high market values well priced stocks are hard to find and the income from cash unattractive. To double up on a losing stock is brave and assumes a recovery story.....if you believe that story then stick with the original and hold tight. I certainly cannot judge markets and to try to with the precision of Richard Scott is well beyond my, or I suggest anyone elses, capability, I note of late that your quest for income had led you to some of the more risky areas - probably because the mainstream is fully valued....Too brave for me I think

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