Prospect Theory is a concept that explains how people react when faced with gains and losses in the markets. The early research that went into it was done by Amos Tversky and Daniel Kahneman, two prominent social scientists. The latter went on to win the 2002 Nobel Prize in Economics and write the runaway international bestseller ‘Thinking Fast and Slow,’ which deals with human quirks in behaviour and decision-making. The broad subject is referred to as Behavioural Economics (BE).
I find it fascinating that many people who give financial advice are unaware of the BE research or, if they are aware, do nothing to incorporate it into the advice they give. The implications of the old saying that those who ignore the lessons of history are condemned to repeat them are enormous.
Investors are feeling cocky
That’s especially true with Prospect Theory, which is vitally important in the summer of 2021 because markets have been on an absolute tear. The result is that investors are feeling confident and cocky. One might even say that many have let their guard down. When things go up with so few meaningful interruptions and no specific, readily identifiable storm clouds on the horizon, a dangerous kind of comfortable complacency might set in.
Many people I speak with these days seem unconcerned by the recent run-ups. Despite a series of potential danger signals such as inflation, deflation, the Delta Variant, and implications of climate change, they seem unperturbed.
Kahneman and Tversky showed that, for mostly emotional reasons, people put more weight on perceived gains over perceived losses and that, when presented with a choice offering equal probability of outcome (i. e., a gain of $1,000 vs. a loss of $1,000), most will choose the potential gains.
Advisors as Behavioural Coaches
For that reason, Prospect Theory is also known as the loss-aversion theory, and it offers a simple example of the risk associated with Optimism Bias. Simply put, people like to focus on positive outcomes: often to the minimization or exclusion of other possible ends. Continue Reading…
While most people will be glad to put paid to the year 2020, there remain three business days and several actions on the investing or tax front must happen before December 31, or even today (Tue., Dec 29) if you want trades to settle in time to qualify as a year 2020 taxable event (capital gains or losses, chiefly).
Allow time for trade settlements
According to this piece from Taxtips.ca, the last trading date for 2020 for Canadian and US publicly traded stocks will be Tuesday December 29th in order to record the gain or loss in the 2020 taxation year. Canadian stocks purchased or sold after this date are settled in 2021, so any capital gains or losses on sale apply to the 2021 tax year instead of to the 2020 tax year.
The Canadian market was of course closed on Monday and reopens at 9:30 am today (Tuesday), although the US market was open on Monday too.
Courtesy RBC Direct Investing, where our family does much of our banking (with some editing):
2020 Year End Registered Retirement Savings Plan (RRSP) Withdrawals
For an RBC Direct Investing RRSP withdrawal to be applied for the 2020 tax year, you must submit your online cash requests before Thursday, December 31 by 4:00 p.m. ET.
If you are requesting an in-kind withdrawal please ensure to call an Investment Services Representative prior to 3:00 p.m. ET on Thursday, December 31.
Note: RRSP withdrawals requested after these times will be applied to the 2021 tax year.
2020 Registered Education Savings Plan (RESP) Online Contributions Deadlines
Please note, to make a contribution to an RBC Direct Investing RESP account from an RBC bank account and still claim an applicable government grant for 2020, you must submit your request online before Thursday, December 31 by 7:30 p.m. ET.
If you are contributing from your non-registered RBC Direct Investing account to your RBC Direct Investing RESP account, the cut-off time is 4:00 p.m. ET on Thursday, December 31.
Kindly note online contributions are automatically split equally among plan beneficiaries.
2021 Tax Free Savings Account (TFSA) Contribution Limit
The annual TFSA contribution limit for 2021 is $6,000 Canadian dollars. Any unused contribution room from previous years carries forward.
Please be aware that due New Year’s Holiday, our normal trading hours will be impacted as follows:
Thursday, December 31
– GICs will close at 11:30 a.m. ET
– All other fixed income will close early at 1 p.m. ET
Friday, January 1
– Both Canadian and U.S. markets are closed
– Foreign exchange transactions will not be processed until Monday, January 4
Monday, January 4
– Markets resume normal trading hours
Last day to place trades for 2020 settlement
– Canadian and U.S. equities: Tuesday, December 29
– Canadian and U.S. options: Wednesday, December 30
That’s the input from RBC.
CERB repayment deadline
This year there are also some actions needed on the government grant Covid front, chiefly involving CERB and related programs. CIBC Wealth’s Jamie Golombek had a good summary of this in Saturday’s Financial Post: Click here.
Golombek says Canada Revenue Agency recently sent out 441,000 “educational letters” warning individuals that they may not be eligible for CERB: individuals whom the CRA said it was “unable to confirm … employment and/or self-employment income of at least $5,000 in 2019, or in the 12 months prior to the date of their application.” Continue Reading…
If you take bad investment advice from others, you may end up selling a stock too early or engaging in unprofitable investing strategies
Most investor sayings and clichés have at least a hint of truth. But they can still lead you to take good or bad investment advice, depending on how you apply them.
For instance, you’ll sometimes hear investors say that you shouldn’t fall in love with your stocks. This seems to make sense. You should keep an open mind on your investments, rather than falling in love with them and holding them forever, despite any adverse changes in their business or the field in which they operate. However, investors sometimes use this tidbit of advice as a justification for selling a stock that has shot up unexpectedly.
Unexpected strength in a stock you like is a bad reason to sell
The stock may be stronger than you expected because you underestimated the growth potential or competitive advantages that led you to like it in the first place. Experienced investors can tell you that some of their best stock picks started going up out of proportion to what they expected, and kept outperforming for years. By the time the first significant “dip” or setback comes along in a stock like this, it may have tripled.
Seems a common reaction to watching a sea of red on financial terminals is simply not to look at the carnage. And, depending on how you set up your portfolio, this may not be as bad a thing as it may seem.
So says The Stingy Investor’s Norman Rothery. The blog also features a couple of occasional Hub contributors, Steve Lowrie and Aman Raina, both of whom look at the behavioural finance aspects of such “ostrich” behaviour.
In a previous post on my series on Behaviorial Finance, I reviewed Richard Thaler’s concept of Loss Aversion behaviour. [the Hub version ran here last week.]
The concept states that people will feel more hurt emotionally with a loss than an equivalent gain gives pleasure.
Consequently, we will be more prone to take excessive risks to eliminate that loss.
Thaler also observed this phenomenon in reverse: specifically, in how people behave when they are making successful financial/investment decisions.
Thaler said this behavior gains critical mass in periods that would be described as financial bubbles, in which people are enjoying repetitive excessive gains in their investments. Using the stock market euphoria of the late ’90s as an example, Thaler comments:
“… in the 1990s individual investors were steadily increasing the proportion of their retirement fund contributions towards stocks than bonds, meaning that the portion of their new investments that was allocated to stocks was rising. Part of the reasoning seems to be that they had made so much money in recent years that even if the market fell, they would only lose those newer gains. Of course the fact that some of your money has been made recently should not diminish the sense of loss if that money goes up in smoke. The same thinking that pervaded the views of speculative investors in the boom housing market years later. People who had been flipping properties in Miami, Vegas had a psychological cushion of house money that lured them into thinking that at worst they would be back to where they started. Of course when the market turned down suddenly, those investors who were highly leveraged lost much more than house money. They lost their homes…”
Conventional thinking has been (and I’ve practiced this myself) that when you have gains in a stock you should take some money off the table and sell the equivalent amount you initially invested in and the then hold the profit amount.
Playing with the House’s money
At that point, you are essentially playing with the house’s or in this case the stock market’s money. If we were to lose all that “profit” or house money, we wouldn’t feel we really haven’t lost any money.
However according to Thaler’s observations about Loss Aversion, we will likely take more aggressive, and riskier decisions when the House Money is reduced, which perpetuates the bubble factor. We will either double down on the investment, continue to hold because we feel it is still a high quality investment compared to other investments (Endowment Effect) or engage in other high risk investment opportunities to regain that House Money. During bubble or bull markets periods, it will work for awhile, however at some point that excessive risk will bite back and ultimately that House Money will likely be gone along with part or all of the initial investment they originally put down.
I had a faced a situation that demonstrates this house money behaviour. I had owned a position in NeuLion. It was a very good investment decision, as it was up nearly 90 per cent so I had made a lot of money on paper. Unfortunately, the stock crashed but I was still up 25%. I decided to sell enough stock to cover my initial investment. The remaing stock I had was therefore House Money. At the time I decided to do this because in my mind I could rationalize and live with the fact that I didn’t really lose money even though the stock tanked royally.
The question that I faced was should I buy more stock at the lower price if the fundamentals of company were still strong or sell the remainder of my position if it fell below my loss threshold, which is 20 per cent. Under the Loss Aversion behaviour that Thaler described, I would buy more stock even if the company has experienced a negative game changer moment and is a riskier prospect.
With awareness of these types of behaviours, I decided to not buy additional stock and instead decided to ride the position out to see if the company could turn it around. If it couldn’t and the position fell another 20 per cent, I would sell the remainder of the position.
It’s interesting as normally one of my disciplines I have built up is to sell positions when they cross a minimum return threshold that I am seeking. Normally for me that is in the 20 per cent range but this time, I decided to hold onto the stock for longer, more so for practice as in the past I have realized that I tend to sell shares earlier and in many cases left money on the table. In this example I strayed away from my discipline and while I didn’t lose money, it could have easily gone the other way.
Managing your Greed
Greed ultimately drives this level of behaviour. The theme from this observation is that as much as it’s important to manage your losses, it is equally important to manage your gains, or more plainly, manage your greed. When you make investment decisions, you need to establish a minimum return you are seeking and when you reach that threshold you should re-evaluate the investment to determine if there is still upside or if it makes sense to bank the profit and move on to better opportunities.
Greed gets the better of us in most cases, but again developing a discipline and avoiding the false sense of security that the House Money Effect offers can allow you a greater chance to maximize the profits and benefits of your successful investment decisions.
Aman Raina, MBA is an Investment Coach and founder of Sage Investors, an independent practice specializing in investment coaching and portfolio analysis services. This blog was originally published on his web site and is reproduced here with permission.