6. Put yourself in Bill’s shoes. How would you react to James’s proposal? You are aware that James is more knowledgeable about the real estate market than you are, but you don’t think that he would take advantage of you. He is too good a friend. However, you have now invested $27,500 in Clear Lake. If You sign over your interest to him, you will have to come to terms with a $27,500 loss. If You keep your interest, you risk losing more money. But by keeping your interest you might also recoup your investment if lot sales pick up. What would you do at this stage?
a. Tell James you understand that he is trying to help you and come to terms with a loss by signing your interest over to him.
b. Remind James that he said that this was going to pay for your child’s college education, and you still expect it to do that (in other words, you want to keep your interest).
7. Imagine that six years have passed from the time Bill made his initial investment. As in question 6, James proposes that you sign your interest over to him. In this connection, James also tells you that one of the real estate agents selling Clear Lake lots has offered to purchase all the remaining unsold lots for $35,000. Together with the $8,900 received from the sale of the lot with the model home, the total amount received for all the lots would amount to $43,900. Imagine that James informed you that he had decided to accept the real estate agent’s offer, and then offered you the opportunity to sign your interest over to him. As in question 6, this offer includes James’s taking full responsibility for all future interest payments associated with the loans that were taken out to enter the deal. Would this additional information change your answer to question 6? What would you do in this case?
a. Tell James you understand that he is trying to help you and sign over your interest
b. Remind James that he said that this was going to pay for your child’s college education, and you still expect it to do that (in other words, you want to keep your interest).
Typically, people who have read the case about Bill and his wife do not think that Clear Lake is a particularly good investment for funding a child’s college education. However, once committed financially, they become very reluctant to pull out. When problems begin to develop, they become a little anxious. The majority begins to experience feelings of regret and blame themselves. When James proposes taking over their interest, very few accept his offer in the circumstances I described in question 6. A few more accept the circumstances described in question 7. However, many do not. They cannot come to terms with the loss.
This is a real-world case. So how did it actually turn out? In the end, the real estate investment that went sour did not prevent Bill and his wife from sending their child to college. Chelsea Clinton entered Stanford in 1997 as part of the Class of 2001. By now, you may have recognized the major players in this case: Bill and his wife are President Clinton and Hillary Rodham Clinton. Clear Lake is Whitewater, and James is the late Jim McDougal. Note that the dollar sums I described are quite close to the actual amounts.
James Stewart, in his 1996 book Blood Sport, reports that Jim McDougal did offer, on more than one occasion, to take over then-governor Clinton’s interest in Whitewater. He also reports that the Clintons declined those offers. In what seems to have been a strong case of get-evenitis, Hillary Rodham Clinton is quoted as saying to Susan McDougal, Jim McDougal’s wife: “Jim told me that this was going to pay for college for Chelsea. I still expect it to do that!” (p. 133)
It appears that President and Mrs. Clinton suffered from a particularly bad case of get-evenitis. Their failed Whitewater investment eventually became the responsibility of Vincent Foster, a White House aide who committed suicide. The subsequent uproar led the White House chief counsel at the time, Bernard Nussbaum, to explain to President Clinton that he had a choice: Either take his financial records from Whitewater and appear before a Congressional panel, which would involve a personal and political cost to be borne immediately; or take his chances with the appointment of an independent counsel who would most likely cast an extremely wide investigative net.
As we all know, President Clinton took his chances with an independent counsel, and eventually ended up having Kenneth Starr investigate his Whitewater deal and much more. In early 1998, a scandal erupted involving a sexual relationship between the president and a White House intern, Monica Lewinsky. At the time, the president was defending himself in a suit filed by a woman named Paula Jones, who had accused him of harassment during his term as Arkansas governor.
While being deposed in the Paula Jones lawsuit, President Clinton was asked, under oath, if he had had a sexual relationship with Ms. Lewinsky. As we all know by now, he had in fact been involved with Ms. Lewinsky. At the time of the deposition, he faced a choice. He could take an immediate loss (embarrassment at the minimum) or deny the affair and take the gamble that he would not be caught. Being loss averse, he took the gamble.
When the media broke the story of the affair, the president faced a choice: Admit publicly at once to the relationship; or deny involvement and take his chances.
Is there some kind of pattern here? Being loss averse, Clinton denied his involvement, wagging his finger at the television cameras and proclaiming: “I want you to listen to me. … I did not have sexual relations with that woman, Miss Lewinsky.”
Several months later, he faced Kenneth Starr in a grand jury proceeding and under oath admitted to an inappropriate relationship. By this time, the political establishment was hoping and expecting that the president would address the nation and apologize for deceiving them during the preceding seven months. President Clinton had two courses of action: Address the nation and apologize for his behavior, thereby taking an immediate loss; or admit to some measure of responsibility but make no apology, and instead attempt to refocus the debate by attacking the independent counsel. Even if you did not know how these events eventually turned out, how would you bet at this stage?
As we are aware, the case eventually moved to the floor of Congress, and in December 1998, the House passed two articles of impeachment, one for perjury and the other for obstruction of justice. William Jefferson Clinton thus became only the second president ever to be impeached by the House of Representatives. In 1999 the Senate tried President Clinton and acquitted him on both charges.
In April 1999 the judge in the Paula Jones case cited President Clinton for civil contempt, because he lied under oath. As this book goes to press there are media reports that Kenneth Starr is preparing to indict the president at some point. So the case may not be over. But whatever the eventual outcome, the lesson is clear.
Plenty of Company
Our list of people who suffer from loss aversion now includes the former head of Bear Stearns, a long-time investor in mutual funds, the manager of a group of mutual funds, and President and Mrs. Clinton. Earlier in the book we saw how loss aversion led to the collapse of Barings Bank, and prevented the executives of Apple Computer from terminating the Newton project in a timely fashion (see chapter 3). Later in the book, we shall encounter instances that are more dramatic. However, the evidence about the prevalence of loss aversion among investors goes beyond anecdote and laboratory experiments.
Meir Statman and I (Shefrin and Statman 1985) suggest that people generally sell their winners too early and hold their losers too long. Realizing a loss is painful, despite the possibility of a tax advantage. An investor who recognizes the tax benefit but finds the psychological cost too painful experiences a self-control problem. Some investors find ways to realize tax losses eventually, notably, by using December as a deadline.
Recent work by Terrance Odean confirms that this is so. Odean (1998a) reports his findings on the disposition effect based on a study of approximately 163,000 customer accounts at a nationwide discount brokerage house.
For each trading day and individual account, Odean looked at the value of all the stock positions that corresponded to capital gains. Some of these gains would have been realized on that day, and others would not. Odean
compared the fraction of all gains sold on this particular day with the fraction of losses realized.
Investors who are loss averse realize more of their paper gains than they do their paper losses. It turns out that from January through November, investors realize gains 1.68 times more frequently than they realize losses. This means that a stock that is up in value is almost 70 percent more likely to be sold than a stock that is down. Only in the month of December do investors realize losses more rapidly than gains, though only by 2 percent.
Which stocks do investors trade the most frequently? They trade stocks that have outperformed the market in the two years prior to the transaction. But although investors tend to realize their smaller losses, they continue to hold on to their larger losses. Perhaps investors act like Melvin Klahr, waiting for their paper loss to disappear. One of the big surprises in Odean’s study is that investors sell the wrong stocks. They receive subpar returns from the losers they keep. But the losers they sell subsequently do great.
In a similar vein, Jeffrey Heisler (1994) provides empirical evidence about the impact of loss aversion on futures traders. His data consist of over 2,000 individual futures account–trading histories, containing more than 19,000 trades, covering the period November 1989 through October 1992. The study deals with the behavior of off-floor traders in the Treasury Bond futures market of the Chicago Board of Trade. Heisler found that off-floor traders hold initial paper losses longer than trades that show initial paper gains. Significantly, he finds that when traders hold losers, their trading activity is nonprofitable. Only 24 percent of the accounts in his sample show a profit over the period he studied. On average, off-floor traders lose $17 per contract traded.
Finally, remember the third case, concerning Steadman’s strategy? The example may be an outlier, but Steadman’s approach is typical for mutual fund managers. Keith Brown, Van Harlow, and Laura Starks (1996) report that fund managers who find themselves in the middle of their comparison group by midyear subsequently increase the risk of their fund’s portfolio during the second half of the year. For further details see chapter 12, on open-ended mutual funds.
Summary
Most people exhibit loss aversion: They have great difficulty coming to terms with losses. Consequently, people are predisposed to hold their losers too long, and correspondingly sell their winners too early. I provided several examples of the phenomenon in this chapter. However, there are others to be encountered elsewhere in this volume. Some pertain to money managers. Other examples pertain to decisions by corporate executives who, reluctant to terminate losing projects, instead throw good money after bad.
Chapter 10 Portfolios, Pyramids, Emotions, and Biases
Harry Markowitz, the pioneer of modern portfolio theory, played it both ways. Markowitz developed the theory of mean-variance portfolios, one of the pillars of traditional finance. But he also developed the basic ideas that underlie frame dependence and loss aversion. And when it came time to choose his own retirement portfolio, Harry Markowitz played it the behavioral way (see chapter 3).
Most investors do the same. Playing it the behavioral way means that they base their portfolio choices not on mean-variance principles but on frame dependence, heuristic-driven bias, and something I call the emotional time line. In this chapter I describe how these three elements together shape (1) the kinds of portfolios that investors choose, (2) the types of securities investors find attractive, (3) the relationship that investors form with financial advisers, and (4) the biases to which investors are subject.
This chapter discusses the following:
• the emotional time line—how emotions affect risk tolerance and portfolio choice over time
• why the combination of emotion and framing induces many investors to structure their portfolios as “layered pyramids”
• how a well-designed security must fit naturally into a layered pyramid
• the role of regret in the investor-advisor relationship
• how heuristic-driven bias inhibits investors from diversifying fully, and induces them to trade too frequently
The Emotional Time Line
Why is it important to discuss emotion in a chapter on portfolio selection? Emotions determine tolerance for risk, and tolerance for risk plays a key role in portfolio selection. Note that investing takes place along a time line. In short, investors experience a variety of emotions as they
• ponder their alternatives,
• make decisions about how much risk to bear,
• ride the financial roller coaster while watching their decisions play out,
• assess whether to keep to the initial strategy or alter it, and
• ultimately learn the degree to which they have achieved their financial goals.
Psychologist Lola Lopes (1987) identifies the major emotions along the time line and discusses the way that these emotions influence risk bearing. According to folklore, greed and fear drive financial markets. But this is only partly correct. While fear does play a role, most investors react less to greed and more to hope. Fear induces an investor to focus on events that are especially unfavorable, while hope induces him or her to focus on events that are favorable. In addition to hope and fear, that apply generally, investors have specific goals to which they aspire.
To what kind of goals do investors aspire? Typical goals include purchasing a home, funding children’s college education, and having a comfortable retirement.
Think of the emotional time line as a line where time advances from left to right. Investment decisions lie at the left, and goals lie at the right. Investors experience a variety of emotions along the time line as they make decisions at the left, wait in the middle, and learn their fate at the right. Hope and fear are polar opposites, one positive and the other negative. Picture positive emotion above the time line and negative emotion below it. What happens above the time line as time progresses from left to right? Hope becomes anticipation and is then transformed into pride. Below the line, fear becomes anxiety1 and is then transformed into regret. You may recall from chapter 3 that Harry Markowitz talked about the importance of regret when planning his own retirement, saying “my intention was to minimize my future regret.” [Money magazine, January 1998, p. 118.]
Hope and fear affect the way that investors evaluate alternatives. Fear causes investors to look at possibilities from the bottom up and ask, How bad can things get? Hope gets investors to look at possibilities from the top down and ask, How good can it get? In Lopes’s terminology, the bottom-up perspective emphasizes the desire for security, whereas the top-down perspective emphasizes the need for potential on the upside. Lopes tells us that these two perspectives reside within all of us, as opposite poles. But they tend not be equally matched: One pole usually predominates.
Barbara O’Neill (1990) has compiled an interesting collection of financial planning cases. The title of her book is How Real People Handle Their Money. Here is an example from her casebook, describing the situation of one particular couple, Barbara and Leon Smyth.2
If they lived in a big city, instead of a rural area, you could probably call them “yuppies.” Barbara and Leon Smyth, ages 35 and 37, are a two-career couple who earn a combined $45,300.3 They have a son, aged 14, from Leon’s previous marriage. … Like many married couples, the Smyths have different attitudes about money. While Barbara is most concerned about safety of principal, Leon’s major objective is future growth and he says he’s willing to assume some risk to achieve financial gain. [Case study # 21]
The dominant emotion in Barbara is fear, and it leads her to emphasize security. For Leon, the dominant emotion is hope, and it leads him to emphasize potential. One of the great contributions of Lopes is to establish how the interaction of these conflicting emotions determines the tolerance toward risk. If there were one important point to take away from this chapter, this would be it!
Portfolios, Goals, and Risk Tolerance
What about the Smyths’ portfolio? Does it r
eflect the emotional profile of Leon and Barbara with respect to security, potential, and aspiration? The Smyths have two major financial assets: a money market account and a growth mutual fund in a custodial trust that is earmarked to fund their (Leon’s) son’s college education.
Financial planners often suggest that investors form portfolios using a layered pyramid. Figure 10-1 offers a representative example from a book by Ginita Wall (1995). The pyramid is structured to address the needs associated with security, potential, and aspiration. At the bottom of the pyramid are securities designed to provide investors with security. These include money market funds and certificates of deposit. Further up the pyramid come bonds. Financial planners often suggest that investors earmark particular investments for specific goals. A common example is to use zero coupon bonds to fund the goal of providing for children’s college education. Climbing up one more layer in the pyramid takes us to stocks and real estate. As Wall indicates, these are intended for appreciation, upside potential.
Figure 10-1 A Portfolio as a Layered Pyramid
A typical layered pyramid that financial planners use to advice clients about building portfolios. Movements from bottom to top involve moving to riskier assets. Movements from right to left involve higher yield. Source: The Way to Save, Ginita Wall, 1993.
Beyond Greed and Fear Page 17