The Rationality and Irrationality of Investment Decisions
Transcription of interview with Terrance Odean on July 11th 2011:
Douglas Goldstein, CFPÆ, Financial Planner & Investment Advisor
Douglas Goldstein: Weíre happy to have Terrance Odean back with us.
Terrance is a Professor of Finance at the Haas School of Business at the University
of California in Berkeley.
His research focuses on how psychologically motivated decisions affect the way investors
make decisions and how they affect prices.
He has recently come out with a new paper, and weíve invited him back to talk to us.
How are you doing today, Terry?
Terrance Odean: Iím happy to be here.
Douglas Goldstein: So tell me, whatís your new study all about?
Terrance Odean: This is a study done with two colleagues - Brad Barber at UC Davis and
Michal Strahilevitz who is at Golden Gate University and is an Israeli who llived in
Israel for many, many years.
The title of the paper is Once burned, Twice Shy: How NaÔve Learning, Counterfactuals,
and Regret Affect the Repurchase of Stocks Previously Sold.
What weíre interested in here is the psychology of investing, mostly focusing on individual
investors, what makes them buy the stocks they buy.
In our study, weíre trying to figure out what makes them sell the stocks they sell.
What I think is one of the insights of this paper and the work that my colleagues and
I have been doing is that when investors buy stocks, usually this is a forward looking
process.
People are buying because of what they think is going to or they hope is going to happen
in the future, but most sellers are backward looking.
People like to sell for a game because it makes them feel good.
They feel bad if they sell for a loss so they hold on to their losers.
The exception of the buying side is if someone has owned a stock recently like in the last
year or two.
Then, what happened when they owned it the first time and what has happened since they
sold it are what determine whether they buy it again.
In short, people like to buy stocks theyíve owned before if they made money on it the
first time, and if they can buy it at a lower price then they sold it.
Douglas Goldstein: Thatís interesting.
Iíve spoken to people and clients coming to my office during my day job when Iím a
financial advisor.
Sometimes theyíll say, ìDoug, I watched the stock.
It trades between about 40 and 50.
What I plan to do, my strategy, is Iím going to buy it when itís trading around 40 and
Iíll sell it when it hits about 50,î and then all these wait.
I see this over and over again.
Is that would people to expect to happen?
Terrance Odean: Yes.
First of all, we know that people tend to expect the recent past to repeat itself.
Thatís why in general, if you see people buying a stock they had owned before, thereís
the overwhelming tendency to buy stocks with strong recent returns.
People like to buy things that have been going up because they believe that they are going
to continue to go up.
So this idea of buying something thatís going down is exceptional and it tends to run in
the way you just described.
People have been following the stock, they may have had experience with it, and they
think, ìOh, itís going to go through this down-up cycle.î We think that investors also
tend to match their trading.
They canít do what youíd really like to do, which is buy stock before it goes up and
sell it before it goes down.
You canít choose to hold onto stocks that go down and wait until theyíve gone up until
you sell them, and you can choose only to repurchase stocks that youíre able to sell
at a higher price and buy back at the lower price.
People match the trading behavior that would make them a profit when they can, but actually
itís not profitable.
For example, we take a look and see that the stocks that people sell for profit and repurchase
at a lower price after they repurchased them underperform the market.
So the behavior that weíre documenting is not improving their performance.
Douglas Goldstein: So just to clarify.
When someone buys a stock and makes money on it and sells, it actually realizes the
gain and then he keeps an eye on this company.
When he sees it drop, heís inclined to buy it back thinking when it drops below his previous
sale price then he buys back in?
Terrance Odean: Yes.
Thatís the pattern that we document.
What we think is driving this is to a large extent that people are trying to avoid the
feeling of regret.
So if you sell a stock for a loss, chances are you donít really want to spend much time
thinking about that.
You feel bad that you sold for a loss.
You regret that you bought it in the first place.
When you sell for a loss, itís sort of permanent that the investment didnít work out.
So youíre not likely to think about it.
Youíre not likely to buy it again to put it back in your portfolio where it reminds
you that you screwed up the last time.
You are more likely to buy a stock that you sold for a profit and youíre not likely to
buy it at a higher price because if you buy it at a higher price than you sold it, youíre
going to regret that you sold it.
So if I buy something at $80, sell it at $120 and then buy it back again at $140, Iím thinking
to myself, ìWell, why did I sell it $120.
I wished Iíd never done that.î But if you can sell it at $120 and buy it back again
at $80 or $100 then you get to regret it.
You could say, ìI sold for profit and I was really smart.
I got on it the right time.
I got back in it at the right time.î So we think that largely investors are trying to
enhance their emotional experience, just to an extent at the cost of their financial gain.
Douglas Goldstein: Weíre talking to Professor Terrance Odean, who is at the University of
California in Berkeley.
He is a specialist who speaks very widely about how people make decisions about their
investments based on all sorts of emotional reasons, very few of them perhaps rational.
So based on what youíre telling me now, do people ever make rational decisions on their
investments?
Terrance Odean: Yes, people do make rational decisions.
There are lot of people who are very rationally choosing to save for retirement and put their
money in well-diversified and low-cost mutual funds and hold it there for a long time, and
that all looks pretty rational.
But there are also investors who turn their own accounts or run up their transactions
cost, buy and sell largely because of their emotional response to whatís going on rather
than sort of a clear considered plan.
So we have a world with bull types of investors.
I focused a lot of my research on the ones who are trading more actively.
Itís hard for me to establish that people are making decisions based on psychological
issues when I donít see them doing much.
I hope that some of this research helps the investors who are not behaving and not optimally
on it to learn to trade better and invest better.
Douglas Goldstein: One of the things you mentioned before was that the study that youíre involved
in now has to do with regret - that people are trying to control whether they will regret
the decision that they made previously.
Other research youíve done is more on fear.
Does one of these emotions have more of an influence than the other?
Terrance Odean: I havenít actually explicitly studied fear.
Iím working on a project right now thatís experimental economics, where weíre trying
to sort of see what happens when you induce the feeling of fear.
We have people watching 5 minutes from a horror movie and then trading in an experimental
market.
We find actually that there is less irrational difference under those circumstances.
We donít get bubbles on those markets as much as if we showed them an exciting video.
The lowest instance of bubbles seems to be when you show them a very boring video, which
gets them in a subdued mood.
I think that fear enters when everythingís been running pretty smoothly and then suddenly
it looks like the world is changing and people remember that they can lose money.
A couple of years ago, when the market started to dive and it wasnít clear how far it could
go down, there was a lot of fear.
My friends who are financial advisors said that they were spending their days trying
to keep their clients from panicking and pulling everything out the market.
This was a big problem.
One of my good friends, only had two clients who overruled her and said, ìTake everything
out and put it all inî the equivalent of money market funds.
She said, ìThat meant that they wouldnít be able to retire when they had thought they
would.î
Douglas Goldstein: You mean that they locked in on their losses at that time.
Terrance Odean: Exactly.
They locked in their losses, and she said they were downing30% to 40% because they had
a mix of stocks and bonds.
She said, ìTheyíve just given up on the possibility of recovering that.
If the market comes back, this is going to mean that theyíre going to have to work for
another 5 to 10 years.î Those particular clients sold within 2 weeks of the battle.
In general, I understand itís extremely difficult when the market is tanking and you donít
know how far it could go to just sit there.
Douglas Goldstein: And you feel like you should do something.
My experience was similar also with clients around that time.
We were also talking to people about still looking at the long term.
I think I only had one client who said, ìDoug, itís all well and good in that long-term
stuff but I think the world is coming to an end, sell.î It was only one guy and everyone
else understood.
They were unhappy because no one likes watching the market go down but they understood what
was going on.
Terrance Odean: So I think what people need to do, and you donít need to be a client
to do this, is think the scenarios to an advance and decide what youíre going to do rather
than make the decision when youíre feeling fear and panic.
You might have a rule that might involve selling at some point, but what you really donít
want to do is panic when the market dives and you sell everything.
Some other people stay out and then they get back in after the market recovers, and while
itís very difficult to predict what the market is going to do, itís fairly easy to stay
if you have a strategy of selling after big drops and buying after big gains.
Douglas Goldstein: The buy high-sell low approach to investment.
Terrance Odean: Itís not going to work out that well.
Douglas Goldstein: Yes, we discovered that also.
Terrance Odean: Thatís a very common emotional response though, because if the market has
gone down, they think itís going down and if itís going up, they think itís going
up.
In fact, the language describes the market that way.
People say to me, ìThe market is going up,î and my response usually is one of the lines
of, ìWhat you mean is it has recently has gone up.
Neither you nor I know what itís about to do.î They think real estate is going up,
real estate is going down, thus the language itself projects the recent past into the future.
Douglas Goldstein: Yes, thatís exactly what happens.
Terry, weíre just about out of time, but the research youíre doing is fascinating.
Tell me in the last minute, just how people can follow what youíre doing and especially
some of the new information that youíre uncovering.
Terrance Odean: You mean to see whatís going on with our research?
Douglas Goldstein: Yes.
Terrance Odean: My postings are on my website www.odean.org and the new research gets posted
on the website.
If you want to look at research in finance and generally whatís going on, there is a
website www.ssrn.com.
Most research is post there and our recent working papers on that website and then of
course Scottward Google where you can find almost anything.
I and most of the academic researchers try to keep our most recent stuff posted so that
our colleagues and your listeners can read about it.
Douglas Goldstein: Great.
Weíve been talking to Professor Terrance Odean from the University of California, Berkeley.
You can check out the research that heís doing at www.odean.org.
Terry, I want to thank you again for being on the show and I hope weíll have you back
on again soon.
Terrance Odean: I look forward to it.
Thanks a lot, Doug.
Douglas Goldstein: Thanks.
Douglas Goldstein, CFPÆ, is the director of Profile Investment Services and the host
of the Goldstein on Gelt radio show (Monday nights at 7:00 PM on www.israelnationalradio.com.
He is a licensed financial professional both in the U.S. and Israel.
Securities offered through Portfolio Resources Group, Inc., Member FINRA, SIPC, MSRB, NFA,
SIFMA.
Accounts carried by National Financial Services LLC.
Member NYSE/SIPC, a Fidelity Investments company.
His book Building Wealth in Israel is available in bookstores, on the web, or can be ordered
at: www.profile-financial.com (02) 624-2788 or (03) 524-0942.
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