Managing Emotional Capital

"Far more crucial than what we know or do not know is what we do not want to know." -Eric Hoffer

Feeling the Market

From the Homo-Economis of Classical Finance to modern quantitative equity models, professionals have sought to eliminate emotions from financial thinking and, by extension, decision making. According to the growing body of work in Behavioral Finance, emotions are present in virtually every investment decision. And the less disciplined the activity the greater the opportunity for behaviors to drive decisions. For equity managers the trouble spot usually is selling. The emotional make-up of a manager, the prevailing calm or turbulence in the market, and the portfolio's returns relative to its benchmark all influence which behavioral need may affect a sell decision.

In this essay we consider managing gains. Why might a manager savor the feeling of owning winners too long or, conversely, allow the fear of regret to push gains out of the portfolio too quickly?

Gains and Pleasure

Holding winners is its own reward.

Separate from the boost to return they provided on their way up, these winning positions signal that you made good decisions. The positive feelings managers have from these decisions are sometimes translated unconsciously into positive feelings about ourselves and our abilities. Wall Street Journal financial writer Jason Zweig, commenting on emotions and investing says, "Your mood can substantially impact your decision processes. And, very often we are not even aware that our mood has changed. Thus, the same stimuli can cause us to choose or make very different decisions with a shift in mood that we are not even aware of."

Selling winners, and the ebullience they provide, creates unique challenges to professional investors. For those with little or no predisposition towards self assessment the emotional forces surrounding selling are too often managed with behavioral responses like Denial, Self Affirmation and Hindsight Bias.

Selling Means Regret

On the flip side, behavioral tendencies can lead to the opposite selling phenomenon — investors' proclivity to sell winners too quickly rather than holding them too long. The most referenced explanation for high turnover of winners is the Disposition Effect. This suggests that investors prefer selling winners over losers in order to experience the pleasure of being a winner and postponing feeling like a loser. Another strong motivation for selling winners is the fear of regret. Regret can come about if the winner you own suddenly drops in price, or worse, becomes a loser. The self recrimination resulting from having a winner slip through one's fingers can be painful and debilitating.

We all have underperformed in a clutch moment — a missed putt, a bad volley, an "air ball" instead of the hoop or the proverbial grounder sailing between the legs. Whatever your specific moment of public mortification, its mere memory may still cause you to cringe or want to hide. Avoiding psychic pain such as this is a highly developed defense mechanism our brains engage in without conscious encouragement, the unintended result of which may lead to taking profits sooner than necessary.

Selling The Past

Reflecting on why selling may be more problematic than buying for most managers, Professor Terrance Odean of U.C. Berkeley explains, "Most of the behavior seems to be affected by what's happened in the past and whether you can feel good or bad about the sale." A manager buys a position precisely because of his/her expectations for that stock. During the course of ownership, as the price of the stock moves it also carries with it the investor's hopes and fears. Arnold Wood of Martingale Asset Management offers these insights: " ... this state of mental tension that we get into when we're confronted with whether or not to sell, what we do with our expectations and our beliefs, and how those can be flip flopped between regret and hope, hope and regret - and back and forth - affect how we sell."

So, what can professionals do to reign in emotions while making sell decisions?

A Capital Idea

All too often managers have only their memories and portfolio returns to provide feedback on sell effectiveness. This is inadequate information from which to learn how well you are doing. Professor Terrance Odean puts it this way: "To really understand how well you're doing, how good say your sell decisions are, requires some sort of analysis." According to Martingale's Wood, this means more than return analysis. "You learn well when you get quick, clear, unambiguous feedback. And you don't get that in the market."

The challenge then is to harness the most from your winners by understanding what, if any, behavioral tendencies are at work. Are you susceptible to a persistent tendency? Is letting your winners run good portfolio management or cashing in on psychic rewards? When you sell, is it because the positions have piqued or to manage an unspoken fear of price reversal? Some managers keep journals of the "why" for each sell. A few even follow the performance of sells to track how they do after being sold. The key is to manage all your assets effectively – especially your emotional capital.

References:
1. "Mind Games", "Welling@Weeden", an on-line research journal, May 11, 2007, Volume 9, Issue 9, an interview with Jason Zweig.
2. "Know When To Fold 'Em", Institutional Investor, June 24, 2008.
3. "Discipline Your Selling", a web cast produced by Cabot Research LLC, June 19, 2008, with Terrance Odean and Arnold Wood. Click here to listen to the recast.
4. "Bearing Up In A Bear Market", by Michael Ervolini, Pensions & Investments on-line magazine, June 9, 2008.