Santa Clara University Professor Meir Statman wrote an interesting article on behavioral finance for today’s Wall Street Journal.  The Mistakes We Make—and Why We Make Them focuses on eight key mistakes that investors typically make particularly when coming to terms with unrealized losses in their portfolios.  Although most value investors already recognize these behavioral tendencies and have an investment framework equipped to counter the worst of these psychological impulses, all investors are subject to emotion and are well served to keep the subject of behavioral finance in mind.

The Pain of Unrealized Losses

Prof. Statman identifies one of the worst psychological tendencies related to unrealized investment losses:

Investors tend to think about each stock we purchase in a vacuum, distinct from other stocks in our portfolio. We are happy to realize “paper” gains in each stock quickly, but procrastinate when it comes to realizing losses. Why? Because while regret over a paper loss stings, we can console ourselves in the hope that, in time, the stock will roar back into a gain. By contrast, all hope would be extinguished if we sold the stock and realized our loss. We would feel the searing pain of regret. So we do pretty much anything to avoid that pain—including holding on to the stock long after we should have sold it.

Value oriented investors have the intellectual framework to counter this tendency because the focus is always on the intrinsic value of a business versus the current quotation rather than a comparison between the current quotation and the cost basis.  This is a critical distinction.  The vast majority of investors psychologically anchor to their cost basis in a security and are reluctant to sell at a loss because they want to “break even”.  On the other hand, value investors are constantly evaluating the intrinsic value of their holdings and comparing that value to the market quotation.  The time to sell a security is when the market quotation approaches intrinsic value and has nothing to do with the investor’s cost basis.

Of course, the cost basis does matter to the extent that an investor seeks to make money in his operations over time.  However, once a security is owned, the relevant factor shifts to the current market quotation vs. the intrinsic value of the security.  If a mistake is made by paying too much for a security due to a faulty estimation of intrinsic value, it may make sense to sell at a loss if the market quotation is at or above the corrected estimate of intrinsic value.

Value Investors Have Advantages But Still Face Behavioral Risks

All investors are human beings with emotions and that obviously includes those of us who have adopted a value approach.  The intellectual framework provided by value investors such as Benjamin Graham, Warren Buffett, Charlie Munger, Philip Fisher, and others provides a key advantage but it is up to all of us to control our emotions and to act rationally both in times of exuberance and despair.  If we fail to do so and act emotionally, the advantages provided by the value approach will be lost and we will have no advantages over speculators.

For most investors, the key to avoiding emotionally driven decision making rests with appropriate asset allocation.  Any investor or speculator who lacks sufficient cash to pay current expenses is likely to be emotional when security prices fluctuate.  By having an appropriate cash allocation sufficient to cover several years of expenses, an investor is liberated from focusing on short term fluctuations and can look at intrinsic value in a more detached manner.   Attempting to allocate funds to stocks that will be required in the near future for expenses will allow emotion to overrule rational thinking for nearly any investor.

Disclosure:  The author’s alma matter is Santa Clara University.