Are You A Rational Investor? Take This Simple Test

Brad Briggs's picture

Monday, August 1, 2016 - 12:30pm

by Brad Briggs

Stop me if you've heard me say this before, but most investors lose money in the stock market.

I don't say this to be curmudgeonly -- I say it because that's what you need to hear. After all, you subscribe to one of our free newsletters because you want to be better than the average investor. And to do that, it's important to understand this first and foremost: most investors lose money in the stock market.

To understand why, it's important to have an understanding of basic human psychology. But I don't want your eyes to glaze over as you read this, so let's have a little fun with it...

I picked up on this thought experiment from Gary Belsky and Thomas Gilovich in their book "Why Smart People Make Big Money Mistakes". I've mentioned this book off and on over the years -- it really is one of the best books out there on the field of behavioral economics. (I highly suggest you pick up a cheap used copy on Amazon or at your nearest bookstore. It's a quick read.)

First, I'll present two scenarios. Then I'd like you to think about what you would do in each one.

Scenario 1: Imagine that you have just been given $1,000 and have been asked to choose between two options. With option A, you are guaranteed to win an additional $500. With option B, you are given the chance to flip a coin. If it's heads, you receive another $1,000; tails, you get nothing more.

Which option would you chose?

OK, now stay with me here...

Scenario 2: Now imagine that you have just been given $2,000 and are required to choose between two options. With option A, you are guaranteed to lose $500. With option B, you are given the chance to flip a coin. If it's heads, you lose $1,000; tails, you lose nothing.

Now which option would you choose?

Traditional economic theory states that people make rational financial decisions based on the probability of future events. This implies you should be consistent with your decisions in both cases. After all, if you choose option A in scenario 1 and scenario 2 -- the certain gain in the first version or the certain loss in the second -- you end up with $1,500 either way. With option B, you have a fifty-fifty chance of ending up with $1,000 or $2,000 in each scenario.

Got it?

In other words, if traditional economic theory holds, the only thing that should matter to you is whether you're willing to take the certain, but smaller, gain or whether you're willing to gamble to win more money.

But according to Belsky and Giolvich, that's not how most people think. When they tested these scenarios on a group, nearly all of them chose option A in the first (guaranteed to win an additional $500) and option B (lose $1,000 with heads, lose nothing with tails) in the second. Why?

Because they're human...

The field of behavioral economics teaches us about human behavior as it relates to economic decisions, and it suggests that humans are not rational when it comes to finances.

This phenomenon is apparent in the two scenarios provided above. After all, your choices are basically the same in both scenarios. Yet despite this, most people will choose option A in the first scenario and option B in the second. This means that humans have a tendency to be more conservative when it comes to booking a sure gain, whereas we'll take more risk if it means avoiding certain losses.

As Belsky and Gilovich note, this explains why gamblers increase their bets when they start losing money. They're willing to be more aggressive to avoid finishing the evening with their ledgers in the red.

It also helps explain why most investors sell their winning positions too early and hang on to their losing positions for far too long. The fear of losing money on a stock is far stronger than the joy from achieving additional gains.

Ask yourself how many times you've sold a winning stock just to see it surge another 10%-plus in the days and weeks that followed. On the flip side, think about how many times you've held on to a loser just to see it keep falling.

As you can imagine, this tendency can have a devastating effect on an investor's portfolio...

According to research completed in 1997 by Terrance Odean -- while a graduate student at the University of California, Berkley -- the stocks investors sold went on to outperform those that they continued to hold by roughly 3.4 percentage points in the 12 months following the sale. You don't need a PhD to understand that, over time, those 3.4 percentage points add up.

It's important to understand these kinds of psychological tendencies. We all have them. But if we can first know ourselves and then overcome those tendencies, we'll be able to guide our portfolios to greater heights. For instance, my colleague Jimmy Butts eliminates these tendencies with his Maximum Profit system. By using concrete technical indicators (relative strength and cash flow relative strength) to time buys and sells, Jimmy and his readers remove emotion from the equation.

So far, this strategy has produced staggering results, like:

- A 70% return from Southwest Airlines (NYSE: LUV)
- An 85% gain from Alcoa (NYSE: AA)
- A mind-blowing 181% gain from Lannett Company (NYSE: LCI)

And here's the kicker... each and every one of these gains came in less than 13 months. It's no wonder then that Maximum Profit has been our most profitable investing system at StreetAuthority since 2014. And now, we'd like to share it with you. To get more information on how to take the emotion out of investing with the Maximum Profit system, simply go here.

Brad Briggs does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.