The decision-making process has been studied for many years by researchers in behavioral economics. We have worked in the field of mental accounting and show how we have deceived ourselves in the field of investment.
What is this about mental accounting?
Both businesses and individuals have to organize their financial lives. Companies have accounting teams (when this is warranted) that control revenue and costs in 3 steps:
- Codification – The main revenue and cost headings are identified;
- Categorization – Revenues and costs are put into accounts;
- Assessment – The accounts are evaluated and control measures taken.
People think in a similar way. We identify our income and expenses by assigning them a category. We have domestic expenses, fun, transportation, investment, preparation of the reform, among others.
Mental accounting makes life easier
Doing this mental accounting allows us to make decisions faster. We save on time and complexity. Decisions are faster, more assertive interpretations and more immediate control measures.
In investments everything works in a similar way. But we are faced with a problem. If the revenues and expenses are put into accounts we must decide when we close these accounts. When we talk about an investment this is seen in practice when we record a profit or a loss.
When do we record the gain (or loss)?
Imagine buying an action. As you know, the value of stocks fluctuates every day. It can rise or fall, and its evolution is uncertain. It stands for reason that we invest to make money but we risk seeing our expectations hit.
Now, when do we feel the gain or loss? Do we feel the moment it occurs or the moment we sell the action (and close our mental account)? In this section we can speak of two concepts (being not very strict):
- Accounting Gain – The price swing is recorded in our mental accounts as a gain or an accounting loss.
- Real gain – We record in our accounts the gain or loss when we sell the share.
Why is this important?
In practical terms, any oscillation in price makes us richer or poorer in any of the scenarios. However, for some reason we think we only lose money if we sell the stock, something that causes us to make a serious mistake:
We tend to sell the winning shares and retain the losing stock
Not only do we see this error in our portfolio today and in the future. Taking a real loss is painful. We do not like to admit that we make mistakes, much less like losing money. It turns out that these are the rules of the game. Those who invest must be willing to win and lose. And we do not admit the mistake we end up not learning from it. Our mental accounting mechanism leads us to make a mistake that is financially penalizing.
And when the losses are devastating?
This scheme of decision is penalizing as we have seen. But it can be catastrophic when we refuse to make a bad decision over time. We have numerous examples of investors who have bought shares of several companies in Portugal and have been avoiding recognizing a loss (selling the stock). The expectation would always be that the price would recover. Until he did not recover, which translated into:
- Although the loss is large, we are less and less sensitive to loss of value. The expectation of price recovery fuels and we very much feel this hope in something that economists call marginal gain (we are more satisfied with a recovery from a gain than even though they are financially the same);
- Mental Account Change. When we lose a lot of money, we move those shares from the investment account into another account that we can call long-term investments or lost cases. By changing the mind account we end up changing our stance on this investment and this may justify many people paying too much commission on the maintenance of the securities portfolio compared to the value of their assets.
What can we learn and do?
First, we must recognize that we are losing money when prices fluctuate in value. And this is positive because if we do a good analysis the probability of earning money is greater than the probability of losing money on investments. It is not guaranteed, but it is likely.
Secondly, we should make an appropriate analysis and follow-up of our investment portfolio, trying to understand the reasons why investments go well or badly. And act accordingly, not being afraid to make mistakes. Never forget that the learning we take from mistakes can be far more valuable than the gain on that specific product.
Although we are all different our behaviors and biases in our decision making process are similar (within groups). These phenomena have already been studied by a lot of people and we must try to learn from these mistakes to increase the probability of making money over time. And then you’ll enjoy it.