Study’s Findings Challenge Loss-Aversion Theory

One tenet of behavioral finance is the “disposition effect” — the tendency for investors to sell winners rather than losers in their portfolio. And a common reason cited for why that occurs is aversion to loss; locking in losses causes pain, while locking in winners causes positive feelings.

But a new study offers evidence that loss aversion isn’t at the heart of the disposition effect. In “Are Investors Really Reluctant to Realize Their Losses? Trading Responses to Past Returns and the Disposition Effect”, authors Itzhak Ben-David and David Hirshleifer find that investors’ beliefs — not preferences, like the preference not to experience pain — are the driving force behind buy and sell decisions. “People have a variety of reasons for trading stocks, which may include tax issues, margin calls, and an aversion to losses,” Ben-David tells Scienceblog.com. “These all may play a role, but what we show [is] that beliefs are dominant for the trading of retail investors.”

Ben-David and Hirshleifer used stock transaction data from 1990 through 1996 from more than 77,000 accounts at a large discount broker, and examined when investors bought and sold stocks, and how much they made or lost on the trades. For example, they looked at when investors were more likely to buy more shares of a stock they’d already purchased. It turned out it was more likely they bought more when the stock had gone down. “If you buy additional shares of a stock that has lost value, that suggests you are acting on your beliefs that the stock is really a winner and other people have just not realized it yet,” Ben-David said. “You wouldn’t buy additional shares of a losing stock if your biggest motivation was to avoid realizing losses.”

Ben-David said acting on beliefs rather than preferences (such as aversion to loss) doesn’t mean investors are making rational decisions — they may be acting because of overconfidence or other factors. He also says that the difference between acting on beliefs and acting on preferences is a key one. “In economics, these two stories are very different,” he says. “Beliefs and preferences are very different concepts, and it is important to distinguish them and how they affect investors. Many economists had thought that an irrational aversion to selling losers was crucial for the trading decisions of retail investors.”

 

Investor Fears Have Rogers Sounding Bullish

Top fund manager John W. Rogers, Jr. says that the combination of lingering fear among investors and improving economic and corporate conditions are signaling a time to buy stocks.

“Housing appears to be bottoming, interest rates are low and management teams at U.S. companies are improving their businesses as a direct result of tribulations encountered in recent years,” Rogers writes in his latest Forbes column. “Cost-cutting has led to record profits, and balance sheets are brimming with cash. That leaves companies in a better position today than they were four years ago.”

Fears remain about Europe and China, Rogers says, but he thinks that investors are overly fearful — and he likes it. “As a contrarian investor, I like it when perceptions are disconnected from reality because it gives me an opportunity to buy quality stocks on sale,” he says. He examines three of his holdings, including CBS.

 

Gardners See Plenty of Opportunities

While a number of recent financial scandals have led many investors to grow weary of the stock market, Motley Fool co-creators Tom and David Gardner say investors shouldn’t lose faith in stock investing. “I think that it is a great time to invest — I have always felt that way,” David tells Yahoo! Finance’s Daily Ticker. “While the backdrop of the system and a lot of skepticism is out there, probably it’s also a sign that there’s a lot of money outside the market, and when it comes back in, I feel really good about where my money’s positioned and the different companies that we own as investors.” Tom Gardner says that investors with a time horizon of less than a year should be nervous, but he and his brother aren’t among that group. He says one can’t evaluate a business and stock in less than six months; they have a 5- to 10-year horizon, he says, adding that investors need to look beyond quarterly earnings when evaluating a firm. They should look at the structure of the business, he says, adding that one key, overlooked metric that correlates with value creation is the rate of employee turnover — the longer employees want to stay at a firm, the more likely that firm is producing value. Right now, he says, there are “so many great businesses out there”.

Value & Momentum: The Best of Both Worlds

In his latest column for Canada’s Globe and Mail, Validea CEO John Reese looks at stocks that have both value and momentum on their side. 

“Don’t chase hot stocks. If you’re a serious investor, you’ve probably heard this piece of wisdom hundreds of times,” Reese writes. “And generally it’s good advice — but incomplete. The full version should be: ‘Don’t chase hot, expensive stocks.’”

Reese says the distinction is a key one. “High-flying, overpriced stocks often lose steam and plummet to the ground,” he says. “But high-flying inexpensive stocks can continue to fly high for some time — and they don’t have as far to fall if their momentum wanes. Used properly, momentum can be a big help in choosing which stocks to buy.”

As an example, he looks at his Motley Fool-based portfolio, which is inspired by the writings of Fool creators Tom and David Gardner. His U.S.-based Fool portfolio, which uses both value and momentum metrics to pick stocks, has gained more than 13% annualized since its 2003 inception, vs. less than 4% for the S&P 500.

Reese looks at a trio of Canadian stocks that get approval from his Guru Strategies (each of which is based on the approach of a different investing great) and have both momentum and value on their side. Among them: Dorman Products.

 

Nygren: Volatility Isn’t Risk

For years, volatility and risk have been synonymous in stock market discussions. But in recent commentary, top performing fund manager Bill Nygren says otherwise.

In a piece posted on Oakmark’s web site, Nygren notes that Oakmarks’ funds have been more volatile this year, and cites a couple reasons. One, he says, is that in a quest for yield in this low-yield bond climate, many investors “have begun to pay nearly unprecedented prices for stocks that distribute most of their earnings as dividends.” That has caused those stocks — which include many telecoms and utilities — to trade like bonds, rising when stocks fall and falling when stocks rise. Oakmark didn’t own any of those telecoms and utilities in the first half of the year, so it essentially lost a hedge against broader market volatility. Another reason for his funds’ increased volatility is that he’s been finding lots of opportunities in cyclical stocks, and investors seem to be willing to tolerate less cyclical risk than in the past, which has made those stocks more volatile, he says.

“But,” Nygren asks, “is daily volatility a good proxy for risk? That depends on how you define the word ‘risk.’ To academics, risk and volatility are synonyms. To many consultants, risk is measured by the variation from an index, called tracking error. We’ve never embraced either of those definitions — we don’t worry about day-to-day volatility, and we’ve never had a goal of tracking any index. To us, risk means losing money. Not just a daily price quote that goes down, but an error in estimating business value such that we want to sell our position despite the price being lower.”

Using those guidelines, Nygren says risk is “highly dependent on the price paid for a stock. When a stock is priced at a premium to its business value, risk is high. When the price is at a large discount to value, risk is low. “

Nygren says that recently, a lot of stock market trends relating to risk have reversed. “Bonds are thought to be lower-risk investments; we believe that, at today’s prices, long-term bonds are very risky,” he writes. “Low-growth, high-yield stocks are thought to be among the least risky stocks; we believe, at today’s prices, they are among the most risky stocks. Investors who simply extrapolate recent trends without comparing current price to value run the risk of buying near highs and selling near lows. As investors today are running away from anything that used to be thought of as risky, we believe they are creating a new class of low-risk, high-return opportunities.”

 

Small, Value, Dividends: The “Triple Threat”

John Buckingham of Al Frank Asset Management says investors should focus on a “triple threat” combination: small-cap value stocks that pay good dividends.

“In investing I would argue that the best long-term returns come from three great ingredients: value, small capitalization and dividends,” Buckingham writes in a Forbes column. “Each attribute separately has been subject to investor adoration. Together they form a triple threat for total returns.”

Buckingham says that, according to Morningstar, small-cap stocks outperformed their large-cap peers by an 11.3% to 8.9% margin (annualized returns) from 1926-2011. Throw value into the mix and it gets even better. According to Morningstar, Buckingham says, small-cap value stocks have produced annualized returns of 13.9% over that period. Large-cap value plays were a distant second, at 10.8%, while small growth stocks returned 9% and large growth stocks returned 8.7%.

As for dividends, Buckingham says his firm has performed its own research. “Over the period from June 1927 through December 2011, the top 30% of dividend payers have seen an annualized return of 11.2%, while the middle 40% have returned 10.3% per annum and the bottom 30% have returned 8.8%,” he writes. “Nondividend payers have returned 8.3%.”

Given all that, Buckingham says, “I think investors who are able to stomach the added volatility should consider buying a basket of small, value-priced, high-dividend-paying stocks.” He offers three picks. Among them: Lexmark International.

 

El-Erian: Risk/Reward of QE3 Getting “Less Favorable”

PIMCO’s Mohamed El-Erian says the Federal Reserve shouldn’t do anything that would disturb the bottoming of the housing market, and says the risk/reward outlook of another round of quantitative easing is getting “less favorable”. El-Erian tells Bloomberg’s “In The Loop” that he thinks the housing market is finally bottoming, though it is a prolonged bottom. He says withdrawing current stimulus or a “fiscal cliff” shock could derail the housing recovery, which he says is “critical” to the overall economic recovery. El-Erian also lays out what he sees as the four biggest risk factors right now. In order, they are the U.S. fiscal cliff, Europe’s debt-driven woes, geopolitical risk, and China’s slowdown.