Investing

Behavioral Economics

As with anything investment-related, see my disclaimers. This post deserves an additional disclaimer. Investing involves risk. Trading stock options is extremely risky and you can lose 100% of your investment. My story is provided solely for entertainment purposes and in no way do I recommend doing what I did. Or anything else, for that matter.

I’m not 100% rational. Few (any?) people are rational all of the time. And even though I am aware of psychological traps and my own irrationality, I still find myself occasionally trapped.

Familiarity Bias

I worked at Dumpster Fire Inc between 2013 and 2017. During my time at DFI, they went public at $40/share and within six months, climbed to a zenith of nearly $100, before falling to the $10 to $20 range for the next five years. I still watch DFI’s price frequently, and my familiarity with the company and its trading patterns lead to a familiarity bias, thinking I knew more about how it operated than I actually did.

Anchoring

During the time that I worked at DFI, I received shares periodically in the form of restricted stock grants (RSUs) and also through an employee stock purchase plan (ESPP). Usually, I immediately sold any shares I received, especially the ESPP shares. 

That is, until my last year at DFI, when I started to hold on to RSU shares. 

Why? I had mentally anchored the stock price to the halcyon days of $60+. And with the stock below $20, it was just a matter of time until it popped back up. Right?

Yep, anchoring bias.

And as the stock continued to drop, my anchor dropped, but always staying higher than the going price of <$20. A trailing anchor, if you will.

It couldn’t go lower, could it? 

Yes, it could.

The stock continued to trade in a depressed range for the next four years, not caring much about my anchor of where it had been.

The Endowment Effect

At DFI, I was restricted to when I could buy or sell shares, usually only during a window of a few weeks each quarter. We still couldn’t trade on insider information during that window, but frankly I don’t think I had access to anything that you could call inside information. So much for my “familiarity”. I was also prohibited from shorting the stock, which includes synthetic shorting through selling covered calls.

Once I left DFI, I no longer had such restrictions. During the summer of 2019, I began selling covered calls to juice my return on shares that didn’t seem to go anywhere. I didn’t write calls against my total position, usually only about 30 to 50% of my total shares, still waiting for the event that would take the stock to the stratosphere.

Would I have bought DFI at the price I was expecting? No. Sounds like maybe the endowment effect had me in its clutches, causing me to give more value to something simply because it was in my possession. 

Excluding my covered calls, my internal rate of return on my DFI shares during that period was 2.66% up to mid-December. If I had sold the shares and put the money into VTI, I would have a return of nearly 14% for the same period.

Recency Bias

Things have been pretty static for the past five years. Of course there’s been indirect COVID-related pressure on DFI, causing me to buy shares both in March and July, only to sell them just a few months later for a short-term gain. Throughout the past eighteen months I’ve been selling covered calls regularly, increasing my returns to 10.3%. It’s been better than doing nothing, but not quite as good as exiting the ride earlier in DFI’s history.

Things looked like they’d continue indefinitely. Until mid-December. Then, bad news struck, dropping the stock 13% in one day. This was actually bitter sweet. I happy because my options would expire worthless, allowing me to repeat the process of selling more covered calls, but sad because my shares were again down in value.

Within a week, the bad news became good news, and the stock jumped 33.7% in one day. Three more days of 5-10% increases left the price 44% higher than when “disaster” struck.

I had fallen into the recency bias trap, thinking the range would continue indefinitely.

The Unknown Bias

I frankly don’t know when the recent roller coaster will end. My calls expired in the money mid-January, calling away 85% of my position in DFI. I’ve already set aside the tax money and started dollar cost averaging the proceeds into my 529 contributions for the year.

However, recently DFI’s stock price has retraced back to $20, making it tempting to buy back in. A group of the calls that expired in January had a $20 strike price, leading me to justify that I was simply buying them back at the price I’d sold them, enabling me to sell more covered calls and get a stepped up cost basis. It would be as if I’d never sold those shares.

I’m sure there’s a bias hiding there. Is it mental accounting, somehow treating the money that I’d tied up in DFI as something special? Loss aversion? More familiarity bias?

If I do buy back in, I’m certainly ignoring my goal to option my way out of the shares in the first place. Sigh.

Conclusion

Those are a few of the bias traps that I observed in myself through my experience with DFI. I’m sure there are more. Like everyone else, investors (or maybe what I’m doing is more speculating?) are plagued with psychology traps that influence behavior, often to their own detriment. Being aware of them is a step towards fixing them.

What kinds of psychological traps do you see in your personal finances or others? What are you doing about them? I’d love to hear about it in the comments.

Hasta luego!

Note: I’m sure my casual return number crunching is riddled with errors.

4 thoughts on “Behavioral Economics

  1. Great writeup! Thanks for sharing!

    I don’t think I’ll ever hold an individual security in my life. Basic portfolio theory says the optimal thing to do to maximize returns and minimize risk is to simply buy and hold the market. By having undiversified positions in a single security, one unnecessarily subjects themselves to idiosyncratic risk.

    Granted, picking the “right” stocks at the right time and existing at the right time is surely more profitable when it goes well. If I had a time machine, I would like to invest in Tesla on March 20 of last year. But, on average, it’s a losing strategy on a risk-adjusted basis.

    If you had the means to get out of your remaining DFI position without taking a big tax hit (for example, if you had harvested some losses you could use), then it would soften the tax blow.

    1. Thanks for the comment.

      Except for DFI, I’m in the same camp with you. I found myself owning DFI and while I have bought it once or twice when it’s gotten super low, I generally stay out of it, preferring to stay in index funds. My justification for DFI shares was through the mental accounting of “found” money, which is yet-another mental bias working against the investor.

  2. That’s great you got company stock to play with, always thought that would be cool.

    l have always worked for “nonprofit” health systems that are not publicly traded, but always thought it would be cool to get stocks from the company I worked for. I thought about working for (HCA – Healthcare), a large for profit system/operator, but I was warned the financial division can be extremely stressful and high pressure. Their stock has done well.

    One psychological trap I am dealing with right now is downsizing my medical office building portfolio. I am trying to get those stocks out of my retirement accounts. I have about $10,000 of DOC in my ROTH IRA there end my exit plan is completely irrational. I actually met the criteria a week or two ago and still didn’t sell. Now it tanked again leaving me another month or more before I am willing to see. Perhaps I need to just start dollar cost averaging out of it. Other than that, my investment house is really cleaning up in 2021!

    Max

    1. The status quo has inertia. That can be both bad and good. Even if you haven’t weaned yourself from the medical office as much as you wanted, at least you’re putting thought in it, the precursor to doing something about it. I personally have enjoyed reading about your DOC/medical REIT experiment, but my status quo/inertia steers me clear of actually investing in it, a good thing because I don’t completely understand that sector.

      Thanks for your comment.

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