Playing Offense with your Behavioral Biases

Behavioral finance books tell us that our brains are flawed and cause us to lose money. To survive, we need to play defense, and stop our bias-riddled brains from bankrupting us. 

In this post, I make a suggestion for how an 'irrational' trade may help you. Two wrongs may not make a right, but two behavioral biases may may you richer (or less poorer - to paraphrase Derek Zoolander). 

'Conventional' behavioral finance wisdom is that human brains are built to make bad investment decisions. Thus, a central theme of behavioral advice is to shackle, smash, cage, sedate, outsmart our 'lizard brains.' Use cold-blooded reason when it comes to financial decisions. 

Behavioral finance tells us to invest rationally

A different idea is that we should embrace our craziness. Humans are not cold-blooded calculation machines and we are never going to suppress our human nature. Is there a way to use our insanity to help us? 

The trade I proposes designed for someone who now feels that his or her investments are too risky. When the stock market was going up (until May of 2015), having a lot of stock investments felt great, and did not even feel risky. Now that the stock market goes up and down by huge amounts every hour, some investors may feel sick. 

Many Investors feel sick because of market ups and downs

If you feel sick about your investments, there is a logical, rational action to take. That is to sell some of your risky stocks.

There are many barriers to selling some risky stocks. First, in the period from 2009-2015, every market dip was soon followed by a rally to new highs. People who sold, felt bad when the market soared subsequently. Second, people have an aversion to selling losers. If you bought Apple at $120, selling it at $95 is very, very unpleasant.

The unwillingness to recognize losses is called the 'disposition effect,' and it is related to what Professors Danny Kahneman and Amos Tversky label this as "loss aversion." Loss-aversion is a robust phenomenon that earned Professor Kahneman a Nobel Prize (Professor Tversky would have shared in the prize, but he was not alive to receive his Nobel).

Amos Tversky

What is a loss-averse investor to do now if he or she wants to trim risk, but cannot stomach recognizing losses?

The "irrational" answer? Rather than sell your existing stock, start a new, short position. This has the same economic impact as selling your loser, but it may feel very different.

Let me make this concrete. Let us say that an investor has $60,000 invested in stocks, and wants to take my advice from last year to sell 10% of the position. Selling $6,000 may be difficult if that would require recognizing a loss. The irrational alternative to 'sell short' $6,000 of the stock market. At the very bottom of this post, I have the specific trade that I suggest.

The trade is irrational in that having two offsetting positions is a higher cost way to reduce risk than simply selling some stocks. For many people, however, it is a controlled approach to reducing risk. The trade can be thought of as buying some insurance.

The specific trades to input into your account follows below.

All the caveats apply. Do not make the trade unless you can take the losses. Do not make the trade impulsively; think about it for some time and enter the trade only when the market is closed. Check with your financial advisor. To summarize all these caveats, recall Gordon Gekko's line. "If you want a friend, get a dog." Financial markets are ruthless.

Here is the trade to de-risk $6,000 of US equity market risk.

1. Sell Short 37 shares of DIA, with a limit of $160/sh.

2.  As soon as the trade is completed, I further suggest you enter a stop-loss on the trade:

Buy to cover 37 shares of DIA, with a stop of $183.36, and a limit of $188.36. Make this order "Good until cancelled."

With the stop loss, the loss on the trade is likely contained to about $1000. So you risk $1,000 to reduce future losses. Much more important that protecting the $6000, is the need to begin reducing risk. Every journey begins with a first step. Every journey to reduce investment risk begins with a sell.

3. Stay tuned.

Postscript July 2016
The Dow Jones Industrial Average made a new all-time high in July of 2016, 14 months after its previous high in May of 2015. 

Chicken Little is Powerless Against Central Bank Money Printing

Chicken Little never bets against markets at new all-time highs; according, when the new high was made in July 2016, Chicken Little bought US stocks to cover a short position, and,  in addition, bought more US stocks to establish a tiny long position. 

Read July 2016 post "Chicken Little Buys US stocks.

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