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Ideas Farm: Own your emotions

Much of the success of contrarian and momentum strategies can be put down to exploiting opposite extremes of the same psychology
Ideas Farm: Own your emotions
  • Momentum investing starts out fun...
  • ...but contrarians have the last laugh.
  • Anyone who keeps their emotions in check can be a winner.
  • Loads of idea-generating data.

A reasonably well-known kernel of behavioural finance wisdom is that owning something changes your perception of its value. The best-known examples of this phenomenon involve experiments that show people put more value on something once it comes into their possession, be it a mug, a pen or a chocolate bar. 

A study from late last year titled 'Ownership, Learning, and Beliefs' by Samuel Hartzmark, Samuel Hirshman and Alex Imas, academics from the Universities of Chicago and Colorado, examines a less well-known psychological dynamic associated with ownership. The researchers looked at how people’s perception of the value of a possession changed depending on whether they had a good or bad experience owning it. 

The carefully designed experiment found that owners tend to overreact to both good and bad news. They were excessively negative when something they own delivered bad results and were excessively positive when it did well. 

These common reactions are behaviours that both momentum and contrarian strategies seek to exploit by playing opposite ends of the psychological gambit.

Momentum traders seek to buy into an emotionally satisfying share price trend with the expectation that other owners – existing and new – will have their perception of value warped by share price rises. Contrarians, meanwhile, seek to pervert their own psychology in order to take advantage of the capitulation of disgruntled owners of poorly-performing shares.

The momentum trade looks more fun at the outset as it plays to our love of owning shares that are performing well. However, if psychology has its way, ultimately such shares should become overvalued, meaning there is likely to be a sting in the tail. The contrarian, by contrast, has an unhappy time building a position in an underperforming stock, but he or she expects to have the last laugh when the selling finally subsides and new investors begin to appreciate the value on offer.

Practitioners of both approaches must try to master their own emotions if they are to execute their strategies effectively. 

Why? 

The 'Ownership, Learning, and Beliefs' study found intriguing evidence to suggest the reason ownership has such a marked impact on our judgement is that it makes us overly attentive to striking new information. 

There are many circumstances in which humans can benefit from having heightened attention for information that could be of direct harm or benefit. However, in the field of investing, where complex and contradictory information has to be calmly balanced, overreacting can be very damaging. 

Our ownership bias – or the 'endowment effect' as academics often call it – is a reason for the pervasive default setting of buy high, sell low (ie, the opposite of what we should want to do). 

One of the biggest advantages all investors should seek to build is a “'behavioural advantage'. Something that helps circumvent emotion and exploit other investors' wonky behavioural defaults rather than fall victim to them ourselves. Creating a system based on rules and processes is the best way to do this effectively. 

Read “Ownership, Learning, and Beliefs” by Samuel Hartzmark, Samuel Hirshman and Alex Imas here

Read our free seven-step guide to building a behavioural advantage here