further pain.
In a recent investigation of the disposition effect in market practi-tioners, Professors Martin Weber and Frank Welfens at the University ofMannheim, Germany, analyzed the purchase and sales transactions of 3,000individual investors at a German online broker from January 1997 to April2001. Weber found that most investors are affected by the disposition ef-fect, but a considerable number (about one-third of the total) display areversed disposition effect, selling their losers more quickly than their
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winners. In another interesting ﬁnding, the investors who sell their win-ners too soon are not the same investors who hold their losers too long.16Weber also found cutting winners short is localized to particular individ-uals, while holding losers too long is a trait that is common across mostinvestors.17
Many studies have teased out the nuances of loss aversion within in-dividuals and across groups. Some characteristics of investors predict apropensity to loss aversion. High-income investors and professionals (inany career) sell their losers more rapidly than lower-income and working-class investors. Investors following aggressive investment strategies selltheir winners more quickly than others. Additionally, loss aversion de-creases as experience increases. For example, investors who trade morefrequently tend to let their winners run, and cut short their losers, morereadily. The longer individual investors held a stock, the less likely theywere to suffer from the disposition effect.18
LETTING WINNERS RIDE
Beware your rationalizations about selling a winning stock—chances arethat you’re unable to identify how your own reasoning is distorted. If you’reguilty of the disposition effect, try the following techniques for minimizingthe impact on your returns:
1. Document your plan for each investment in advance. Know when andunder what circumstances you will sell a stock. Don’t deviate from yourplan. Keep the plan in your trading or tax records.
2. When you feel yourself becoming fearful about a winning position, es-pecially one that has had a terrifying pullback, don’t sell yet. Insteadreevaluate your selling criteria. Did the position meet your proﬁt target?Has something fundamental changed about the security that indicatesyou should sell now? If the price appreciation was rapid and psychol-ogy driven, then it may actually be a good time to get out, but you’ve gotto consider such moves in your plan, in advance.
3. As with the biases above, cutting your winners short is the result ofshort-term emotional inﬂuences overriding your rational thinking. No-tice your emotional state after a position appreciates much more thanyour expectations. Are you afraid of giving back your proﬁts (and feel-ing regret)? Are you worried that you’ll feel stupid if you don’t sell?Do you want to take the money off the table to feel proud of yourself,
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to show off to others, or to purchase something? There can be manyexplanations, depending on your life experiences and your recent ﬁnan-cial progress.
4. Be prepared for your short-term winners to give back some of theirgains. You may want to utilize proﬁt caps (or trailing stops) to takeadvantage of rapid price spikes, but be sure to be systematic about it.Reversals are very common after a rapid, large price rise.
5. Don’t check your prices frequently! This is especially true for long-terminvestors and nonprofessionals. If you are trading in positions of oneyear average duration, don’t check the prices quotes daily. Checking toofrequently leads to increased awareness of volatility, emotional reactiv-ity, and a VERY high likelihood of overtrading. If you have an explicitplan in advance (see number 1 above), remember to follow it.
SUMMARY
Many great long-term investors develop their businesses for the long term.Small setbacks are seen as opportunities, not reasons to sell out. Yet thatis an inclination that most investors feel. When times are good, and darkclouds appear on the horizon, many investors sell out early.
To prevent this inclination to “cut winners short,” professional valueinvestors buy stocks that are steeply discounted from the company’s fun-damental value. As a result, there is less short-term price risk. If the compa-nies become overvalued relative to their fundamentals, then they are sold.The framing effect is the tendency to view investments as either poten-tial opportunities (gains) or potential risks (losses). Depending on whichstance one takes, their choices are likely to be different. In general, mostpeople fear losing. In the realm of gains, they prefer to lock in gains ratherthan risking a loss of their proﬁts. In the realm of losses, they would rathergamble for the chance to lose nothing than accept a guaranteed loss. Thisaversion to losses is true even when the potential gain is twice as great asthe potential loss. This ratio of 2:1 preference for risk is called the lamda.Many things change the value of lambda, including recent events (suchas losses or gains), the framing of the decision problem, one’s personal-ity style, and one’s experience with similar gambles.
Loss aversion is rooted in basic brain structures in the loss avoidancesystem and prefrontal cortex. The loss frame activates these structures anddeviates decisions to become more self-protective. Interestingly, peoplewho are swayed by their fear of losses are often unaware of their intrin-sic decision bias.
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A number of steps can be taken to lessen loss aversion. In partic-ular, investment plans and goals help people stay on track. Every dayupdating your investment perspective to the morning’s opening can reduceanchoring and reference point biases (such as feeling that one is “losing”or “winning” in a position). Keeping track of one’s level of fear about an in-vestment can be useful as well, especially if it is pushing one off plan. Thenext chapter will examine in detail the ﬁnancially destructive but prevalentbehavior of holding losers too long.
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C H A P T E R 15
Loss AversionLearning to Cut Losers Short
“You can’t be afraid to take a loss. The people whoare successful in this business are the people whoare willing to lose money.”
—Jack Schwager1
“I’m not better than the next trader, just quicker atadmitting my mistakes and moving on to the nextopportunity.”
—George Soros
S ome investors “fall in love” with a stock or a position. Maybe they
love the stock because it has had a high return thus far, or they lovethe idea behind the company, or they work for the company andenjoy owning shares. In any case, when investors become attached to oroveridentiﬁed with a stock, they lose the ability to think rationally whenthe time comes to sell. Like letting go of a favorite old car, or cleaning the“junk” out of the basement, selling a stock can feel painful and unneces-sary, even though one wouldn’t purchase so many shares de novo, giventhe chance. People’s propensity to become emotionally attached to itemsthey own, such as stocks, is called the endowment effect. The endowmenteffect is an easily measurable result of loss aversion.
Because investors have difﬁculty selling stocks that they already own,especially if they are losing, researchers surveyed stock investors abouthow much time they spend on buy versus sell decisions. Ninety percentinvestors reported spending more time on buyof active individual
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decisions than sell decisions. However, less than 20 percent said thatbuy decisions were more difﬁcult. Investors are spending less time mak-ing sell decisions, but more than 80 percent report that those decisions aremore difﬁcult.2 What is so difﬁcult about the sell decision? While buy deci-sions are typically based on a consideration of objective information, selldecisions are often emotionally weighted.
Recall that the endowment effect refers to the phenomenon wherepeople overvalue items they own. In a classic demonstration of the en-dowment effect, I randomly gave pens to one-half of “behavioral ﬁnance”seminar participants. I asked the new pen owners to write down some-thing they liked about the pens. The other half of the audience—thenonowners—were asked to write down objective qualities of the pens.As an aside, please note that researchers have found that when subjectswrite down admired qualities of an owned item the endowment effect isenhanced, while documenting objective qualities reduces the endowmenteffect.
The new owners then set a price at which they would sell their pensto the nonowners. The nonowners set a price at which they would buythe pen. The average bid from the nonowners was $1.50 while the averageasking price from the owners was $5.50. The people who owned the penvalued it far more than the non-owners. The pen had actually cost $1.50.In general, investors value items they own more than nonowners do, andas a result, they are reluctant to part with them for what appears to be anexcessively low price.
An interesting example of the endowment effect was noticed in on-line auctions. Researchers proposed that the highest bidders in an onlineeBay-style auction, realizing that they are the highest bidders, might startthinking more concretely about possessing the desired item. As a result,they could become partially attached to it—producing a bias they term aquasi-endowment effect. The researchers found what they had expected.Online auction participants whose bid is highest at some point during anauction more aggressively pursue the item if their high bid is bested byanother’s.3 A similar effect may happen in stocks as investors “chase” theprice higher after missing a ﬁll on a limit order.
As seen in Professor Jennifer Lerner’s studies in Chapter 6, one’s emo-tional state modiﬁes the strength of the endowment effect. For example,sadness prompts people to think about changing their circumstances. Asa result, the endowment effect is eliminated in sad people, since they arenow focusing on shifting their circumstances (selling what they own andbuying items they do not).4
It’s not only emotional states that alter the strength of the endowmenteffect. The intention to spend money on a purchase or, in the case of in-vestors, to sell a stock in one’s portfolio appears to reduce the endowmenteffect. Making up one’s mind to let go of a stock discharges the mental
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constructs that supported ownership. When it comes time to sell, there areno emotional connections spurring second thoughts.
It doesn’t make sense that the endowment effect would persist in pro-fessionals, due to the erosion in proﬁtability it would cause. In structuredexperiments, professional baseball card traders showed a steady reduc-tion (to extinction) of the endowment effect as they traded over manyrounds.5 However, it remains unclear whether the endowment effect is re-duced through experience in stock market participants.
NEUROSCIENCE OF LOSS AVERSION
If loss aversion is so common, affecting almost two-thirds of investors, thenit’s reasonable to speculate that it may have a biological basis. Chapter 14described an fMRI study in the United Kingdom that identiﬁed amygdalaactivation (fear) as one cause of the effect. Interestingly, loss aversion andthe endowment effect are evident in the behavior of monkeys.
An enterprising economist, Keith Chen at Yale University, trained ca-puchin monkeys to use and value “currency” (small metal tokens). He ob-served the choice behavior of his monkeys during a number of differentdecisions, in which they chose among different quantities of one of theirfavorite foods—apple slices. Chen wondered whether biases such as lossaversion are the result of social or cultural learning, speciﬁc environmentalexperiences, or some fundamental neural process shared by all primates.6The tufted capuchin is native to the South American tropics. Capuchinslive in a male dominance hierarchy with a single alpha-male and severalnondominant males and females living in small bands. Capuchins are “ex-tractive foragers”—they prefer easy-to-eat fruit but when pressed are capa-ble of pounding apart hard nuts, stripping tree bark, raiding beehives, andeven killing small vertebrates.7
The capuchins were presented with choices between different quan-tities of apple slices. Some choices were framed as gains and othersas losses. Chen found that the monkeys obeyed many of the axioms ofprospect theory, for example. “Capuchins seem to weigh those losses moreheavily than comparable gains, displaying not just reference-dependencebut loss-aversion.” Chen concludes that “our results may suggest that lossaversion is an innate and evolutionarily ancient feature of human prefer-ences, a function of decision-making systems which evolved before thecommon ancestors of capuchins and humans diverged.”
It’s not just tropical monkeys that are susceptible to loss aversion. Hu-man children, while unable to express gambles in terms of expected value,also demonstrate loss aversion, with no age-diminishing inﬂuence throughcollege.8
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THE EQUITY PREMIUM PUZZLE
The equity premium puzzle refers to the historically high returns of stocksrelative to bonds. According to economists, the average annual real return(i.e., the inﬂation-adjusted return) on the U.S. stock market for the past 110years has been about 7.9 percent. In the same period, the real return on arelatively riskless security was 1.0 percent. The difference between thesetwo returns, 6.9 percentage points, is the equity premium.9 Why U.S. bondsare so popular, even with a relatively low yield, is the puzzle. Individualsmust perceive a signiﬁcantly higher level of risk in stocks than has beenshown historically for the puzzle to be reconciled with “rational” economicmodels.10
Investors are sensitive to volatility, and the more they check prices,the more risk they see in the stock market. When experimenters changethe feedback frequency of price quotes, they ﬁnd that individuals tend toinvest more in equities when the performance of their prior decisions isassessed less frequently (i.e., when they see price quotes less often).11
Professors Shlomo Benartzi and Richard Thaler at the University ofChicago proposed that this feedback-induced conservatism was due to aprocess of “myopic loss aversion.” As people receive more frequent feed-back about price changes, they become short-sighted in their risk assess-ments. Given their more numerous sample periods, frequent price checkershave higher odds of seeing negative price changes, which they perceive asthreatening (risky) to their wealth. Thaler argued that the size of the equitypremium (6 percent) is consistent with investors evaluating their invest-ments annually and weighing losses about twice as heavily as gains.12
Investors’ myopic loss aversion is increased by exposure to both in-formation quantity and frequency. Loss-averse clients may have compelledIsrael’s largest mutual fund manager, Bank Hapoalim, to change the fre-quency of its fund performance reports from every month to every threemonths, while noting that “investors should not be scared by the occasionaldrop in prices.”13
In an experiment comparing university students and pit traders fromthe Chicago Board of Trade (CBOT), traders actually exhibited more my-opic loss aversion than students.14 Floor traders may have honed a skill forrapid risk/reward assessment, which encourages short-term evaluationsand decisions—not necessarily compatible with choosing the best long-term option.
Along these lines, researchers have found that professional traders andinvestors are largely incapable of arbitraging psychological biases out ofmarket prices. Price anomalies such as the equity premium puzzle havepersisted despite the recognition of greater proﬁts available to investorswho understand them.
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So what would a savvy investor do? They should put all their long-termsavings in equities, none in bonds or cash. Unfortunately, this advice is eas-ier said than done, which explains why the equity premium has persisted.
THE IMPLIED PUT OPTION
In early 2006, Brian Hunter, a 32-year-old physics and applied math grad-uate from Calgary, Canada, placed large bets on the convergence of long-dated natural gas contracts (such as the March and April 2007 expirations).As the prices of those and other contracts diverged in September 2006, andHunter lost more and more money, he repeatedly increased his risk expo-sure. By September 2006, Hunter’s ﬁrm, Amaranth Capital, had purportedlylost more than $6 billion (out of a total capital pool of $9 billion). The ﬁrmsubsequently closed, liquidated its positions, and the remaining assets werereturned to investors.15
In 2005, Hunter earned $75 million for his stellar trading performance,with a rally in natural gas prices due to Hurricane Katrina responsible forthe bulk of those gains. While his lifetime trading gains had been spectacu-lar, in 2006 investors in his ﬁrm lost 66 percent of their capital.
Hunter was exceedingly proﬁtable for several years prior to the col-lapse of his fund, yet he may have grown overconﬁdent in his ability tomanage risk. He increased his risk exposure as his losses ﬁrst swelled inMay 2006. Fortunately, his gambit paid off during the summer of 2006. How-ever, Hunter remained excessively exposed when markets again reversedin September 2006, and this time he didn’t get bailed out. The same patternof loss averse trading characterized John Meriwether, the founder of Long-Term Capital Management. In both cases, each trader increased risk ex-posure when losing (loss aversion). Because they couldn’t accept the painof the loss, they held on longer. Occasionally, loss averse investors even“double down” with more capital while insisting that their losing positionsare rational.
Hedge fund traders who take excessive risk operate with an ethicaldilemma in mind. They are working with an “implied put option,” whichmeans that they are extremely well compensated if they take large risksthat payoff, but a catastrophic loss is unlikely to affect them beyond thecurrent year (unless they invested in their own fund). The worst that canhappen to them personally, especially in a hedge fund, is that they lose theirjob, their current income, and any forthcoming annual bonus. In the caseof Hunter, he made $75 million in 2005, and beyond the one-third of hisbonus that he had invested in Amaranth, he will emerge from the debaclewith tens of millions in the bank from his trading in 2004 and 2005.16 Notbad for someone who lost $6 billion in 2006.
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One especially interesting aspect of Hunter’s success and subsequentdownfall is the respect and admiration afforded him by other traders.According to “former Deutsche Bank colleague Bruno Stanziale, 34, ‘Hehas an understanding of the market that others do not.’” Another for-mer colleague remarks that Hunter should get back into trading, “‘Other-wise, it would be too much intellectual capital wasted to have him on thesidelines.’”17 Similar praise was conferred on John Meriwether after thecollapse of Long-Term Capital.
While there is no doubt that both Hunter and Meriwether are remark-able men, it is surprising that many traders miss the essential lesson of theirdownfalls. A few years of hefty proﬁts and sagacious market insights donot immunize traders from the risk of total collapse. Risk management iskey, yet it is often boring and restricts proﬁtability. Firms that are trappedin a death spiral will often take far more risk to get out of their hole. Of-ten, “doubling-down” works, and then an “addiction to risk” can becomeentrenched.
Interestingly, it is excessive risk taking when losing that also char-acterized the downfalls of “rogue trader” Nick Leeson at Barings Bankin Singapore (in 1994) and Toshihide Iguchi at Daiwa Bank in New YorkCity (1995). Like Hunter, both Leeson and Iguchi had been considered“stars” of their ﬁrms and as such had been given less risk managementoversight.
OVERCOMING LOSS AVERSION
“I was determined to win back the losses. And as thespring wore on, I traded harder and harder, riskingmore and more. I was well down, but increasinglysure that my doubling up and doubling up wouldpay off . . . I redoubled my exposure . . . it became anaddiction.”
—Nick Leeson18
It doesn’t feel good to take losses, but it has to be done. Following area number of tips for investors and traders who have noticed loss aversionin their transactions (avoiding selling losers, “doubling down,” and “hopingfor a comeback”). In truth, the result of doubling down may be a reboundin one’s positions and greater overall proﬁts. But, eventually, the reboundwill not come, and one will lose everything.
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Loss aversion usually dissipates with experience, and the followingtips should help yours along into the dustbin of history. Many of the tipsare repeated elsewhere in the book.
1. When you reevaluate your investments holdings, consider pref-erentially selling some of the losers instead of the winners. Askyourself, “All things being equal, would I enter this position today?” Ifyour answer is “no,” then place it on your sell list.
2. Be aware of rationalizations or excuses you make in order tohold a losing position longer. Many traders who break their stop-loss rules report that they wanted to “see if it would come back a littlebefore I sold it.” Don’t believe yourself—while you were waiting for thatretracement, you were rationalizing your poor money management. Youdidn’t want to take the pain. It takes a lot of courage to admit defeat. Andyou can’t regroup for the next engagement until you’ve taken the pain.3. Beware of letting naked options expire worthless instead of sell-ing them according to plan. It is easy to let out-of-the-money optionsor long-dated “low-risk” arbitrage positions sit, hoping for a comeback,rather than selling them for a loss. On a similar note, when shortingstock, be sure to have a stringent (and realistic) sell criterion.
4. Remember that you are more susceptible to loss aversion afterrecent or large losses of any nature. Be aware of losses and disap-pointments in your life and how these may affect your investing.
5. Humility is essential. Developing a reputation as an excellent or in-sightful trader could make you cocky. When you are eventually wrong,you’ll be less likely to admit it, for fear of damaging your reputation.Remember, the markets are always bigger than you.
6. Be sure to set and follow stop-loss rules. If you don’t have a de-ﬁned money management system, then be sure to put one in place. Seenumber 1 above.
THE HOUSE MONEY EFFECT
Most investors are susceptible to investing errors related to loss aversion,such as holding losers too long. Not as many investors cut their winnersshort. In particular, a seemingly contradictory mistake has been notedby researchers. Professor and money manager Richard Thaler found thatmany of his experimental subjects took increased risk after wins, whichhe called the house money effect. The house money name is derived from
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an expression often heard at casinos, where gamblers who bet more afterbig wins are said to be playing “with the house’s money.” They have notyet internalized their ownership of the winnings yet, and thus they aren’tas afraid of losing it.
This contrast between “cutting winners short” due to loss aversionand “letting winners ride” due to the house money effect is franklyconfusing. The existence of these two seemingly contradictory biases canbe attributed to the framing of prior gains. According to professor andbehavioral ﬁnance expert Hersh Shefrin, “If a prior gain is followed by agamble whose maximum loss is not larger in absolute value than the priorgain, then a person might act as if he or she is risk seeking in the domainof gains, in contrast to a situation where there was no prior gain but theunderlying cash ﬂows were the same, and the person was risk averse in thedomain of gains.”19,20 If one is struggling to maintain a proﬁtable tradingaccount, then gains are quickly realized (cut short) in order to cement theaccount in positive territory. However, if an investor is ﬂush with excesscash, then risks will not be as worrisome, and gains will be left to “ride.”
Researchers have identiﬁed the house money effect among marketmakers on the Taiwan Futures Exchange. Every options transaction onthe exchange between 2001 and 2004 was analyzed.21 Market makers werefound to take more risk in the afternoon after a successful morning of trad-ing. Other studies with individual investors have often found the same ef-fect; they increase subsequent trading intensity and take on greater risksafter making proﬁtable trades.22 Among investors, the house money effectis often present among more successful individuals. That is, more success-ful investors are more likely to let their winners run. However, the effectdoes appear to decline with experience.
As noted in the quotation from Hersh Shefrin above, an investor’sframe of reference regarding recent gains or losses often determines whichtype of bias they show. Investors may become excessively loss averse ifthey are worried about giving back proﬁts, while they may become exces-sively risk seeking if they feel that they have “nothing to lose.” In each case,feelings about potential gains and losses are driving risk-taking. In the ex-amples of professional investors below, notice how each prevents himselffrom interpreting gains and losses in ways that provoke an emotional re-sponse.
LESSONS FROM THE POPE
Jim Leitner, manager of Falcon Management, a New Jersey–based hedgefund, is considered by some to be the “Pope” of global macro investing.
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By his own estimate, he has taken $2 billion out of the markets for himselfand his employers over the course of his career. Leitner is hardworking,humble, intellectually curious, and willing to sacriﬁce in the short-term inorder to advance his experience or knowledge. Since founding Falcon Man-agement in 1997, he earned approximately 30 percent annually. Author andhedge fund consultant Steven Drobny interviewed Leitner to discover someof his investing secrets.23
When asked how he can tell when prices are out of line, Leitnerresponds, “I don’t have an innate skill. It comes from being extremelyinterested in markets and looking at everything all the time.” Throughhis interest and experience, Leitner has developed a “mental database ofwhere things should be.”24 In a sense, Leitner has honed his ability to assessexpected value and notice deviations from it on his mental “radar screen.”As a result of his innate evaluation mechanism, which is driven by fac-tual events and prices, not by overt feelings, Leitner describes his tradingas being “absolutely unemotional.” “Losses did not have an effect on me be-cause I viewed them as purely probability-driven, which meant sometimesyou came up with a loss. . . . To this day, my wife never knows if I’ve had abad day or a good day in the markets.”25
How does Leitner remain unaffected by his performance? His ego isuninvolved, because he remains unattached to outcomes. In addition tobeing unemotional: “. . . I’m really humble about my ignorance. I truly feelthat I’m ignorant despite having made enormous amounts of money.” Leit-ner is never trying to prove something with his ability to make money. Heapproaches investing as an intellectual game, one that he loves to play. Leit-ner describes his favorite trade as one in which he made one tick overnighton the Swiss franc by relying on his wits, “. . . My wife still remembers mejumping up and down in the middle of the night screaming ‘I did it! I didit!’ . . . It was the most phenomenal feeling of control and creativity all com-ing together.”26
Leitner displays no hubris or overconﬁdence in his interview—only anintense curiousity about the markets, humility, and a willingness to con-stantly reexamine his assumptions. He does recount an episode when heforgot to be humble: “Finland devalued once when I was working for my-self and I was caught long. I was partially asleep and a bit cocky becauseit had never happened to me before. The trading gods had to remind me tobe humble.”27
For the aspiring investor, Leitner recommends openness to the “en-tire spectrum of market experiences,” avoiding becoming too much of anexpert, and learning not to “buy into stories.” To combat the “buying intostories bias,” Leitner suggests, “We need to quantify things and understandwhy things are cheap or expensive by using some hard measure of whatcheap or expensive means.” Yet we shouldn’t dismiss stories. “A story is
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