Investors: Love thy losers as thou love thyself

Investors have been slow to sell their losing aggressive growth and tech-specific mutual funds in the market meltdown, according to figures compiled by the Leuthold Group in Minneapolis.

In fact, while there was some net selling in late November and December, there was positive net cash flow into those funds in the latter part of January and much of February.

The question is why. Why did investors react so slowly to what must be significant losses in their tech funds? Why do many, perhaps even most, still hold them?

James Bianco, president of Bianco Research LLC in Chicago, using Leuthold Group figures, estimated that as of March 7, investors had unrealized losses in their tech fund holdings of $81 billion. He proposed two possible explanations for why investors have been slow to react to the pain.

First, it is possible the average investor still has slim gains in those funds, having bought earlier than year-end 1996, the starting point for the Leuthold Group’s data. That suggests the selling is yet to come.

Second, these investors have “blown their chance” to sell and now view those funds or stocks as “lottery tickets.” They’ve taken such huge losses that they see no point in selling now. If they sell, they will lock in paper losses, making them real. If they continue to hold, they might get lucky, and their fund or stock might yet recover.

The second explanation fits with insights from an avenue of research called behavioral finance, which examines how people react when money is involved in decisions.

Loss aversion is a recognized behavior from the research. Investors resist turning paper losses into real losses.

But there are other behavioral finance insights that can help explain the unwillingness of investors to sell their losing funds or stocks.

One is mental accounting, a concept studied by Richard Thaler, a professor at the University of Chicago. If the investors still have gains on some stocks or funds that offset the losses on the losers, they consider the losers and winners together, so they don’t feel the loss on the losers. Therefore, they feel no need to sell the losers.

Another phenomenon is called behavioral momentum. John A. Nevin, a professor at the University of New Hampshire, has studied this phenomenon. Mr. Nevin discovered that a history of frequent rewards in a given situation makes behavior more resistant to change when the situation changes.

That is, investors who have been rewarded for a significant number of periods for investing in and holding tech stocks or funds – during the 1996-2000 period, for example – will be highly resistant to the idea of changing that behavior by selling the stocks or funds despite the market collapse.

At some point, however, the resistance may become so painful that the investor surrenders and sells, or as Wall Street says, “capitulates.” Much of Wall Street has been awaiting investor capitulation, and last week may have been the beginning of it. But maybe not.

What happens when the investors finally sell? They regret the decisions that led to the bad outcome, according to behavioral finance research. The investors often take steps to ease or avoid that regret. One tactic, according to Mr. Thaler, is to shift the responsibility for a decision or outcome onto someone else.

This could be good news or bad news for financial advisers.

It could be good news in that some investors who have been making their own decisions may well now turn to advisers onto whom they can shift the responsibility in the future.

It could be bad news for advisers whose current clients are looking for someone onto whom they can shift the full responsibility for joint past decisions that led them to hold tech funds or stocks.

Luckily, there are probably more of the first kind of investor than there are of the second.

Mike Clowes is the editorial director of InvestmentNews

Related Topics: Just Thinking