(exerpt from The Only Three Questions That Count, Ken Fisher, 2007)Pride & Regret

Behavioralists have shown normal Americans (we’ll assume they are normal) hate losses about two and a half times as much as they like gains. A 25 percent gain feels as good as a 10 percent loss feels bad. Said otherwise, if you gain 10 percent over here and lose 10 percent over there, you feel like you’re behind. You feel more chilled by a 10 percent loss than thrilled by a 10 percent gain. Therefore, people exert more effort to avoid pain than achieve gain. This is commonly known as loss aversion, sometimes referred to as myopic loss aversion, intimating shortsightedness and an overactive reaction to short-term movements. It explains many investing errors. At root, myopic loss aversion and the mistakes it leads to are about two things–pride and regret.

Our Stone Age information processors learned to do what is called “accumulating pride” and “shunning regret” as matters of survival. Imagine two hunters returning to camp at dusk. One has a gazelle draped over each shoulder. The other has nothing but some broken spears that missed their mark.

The hunter with the gazelles thrills the camp with his entrance. Before he approaches, he knows he will be regaling the story of his hunt around the campfire that night. He knows his mother will be proud– very proud and elevated among her peers. He envisions the young girls staring at him with doe eyes and even hopes the tribal chieftain may soon think about linking him up with his royal daughter, pulling him into the ruling family. Heady stuff!

That night he tells the tribe the story about how he, skillfully and masterfully, hunted and brought down the mighty beasts. He talks about his deftness in forming the spear and how his spears are particularly deadly. He talks about the signs he interpreted leading him to the grazing gazelles. He details his physical prowess in accurately launching his spear into the gazelle with deadly finality. He accumulates pride. It feels good and motivates him to eagerly go out to hunt, again and again, so he can continue to experience that prideful high. And that is good for the tribe because they need this young man to kill high-powered animal-based protein that went a long way in those days in separating those whose genes passed on from those whose didn’t.

Meanwhile, back at the outskirts of camp the other young hunter, the one with no gazelles, has a different story to tell. It wasn’t his fault he didn’t bag a gazelle. He has skill in spear making and experience in tracking beasts too. But on this particular day, a freak bolt of lightening scattered the gazelles south moments before he could aim. Or maybe someone borrowed his spears so they weren’t sharp enough. Or maybe there were lions roaming in his hunting ground. Or the wind was wrong. He fabricates seeming plausible excuses so he can rise the next morning and try again. He shuns regret. In so doing his campmates let him hunt the next day as well; their belief in his story motivates him to try, try again. His tribe needs him to hunt too. Maybe he really was just unlucky that day. Even if he is a terrible hunter, he may stumble across an injured animal. Maybe tomorrow he will come across a gazelle just after it has been killed by a wild dog. Either way it’s worth it if protein accumulation is possible.

Accumulating pride when successful and shunning regret when failing motivates both hunters to keep trying their hand. Both of these tendencies are good for the tribe. Their tribe’s very survival depends on their willingnesss to make repeated forays. The successful hunter hunts again and again. The unsuccessful hunter hunts again too.

Many sources say investors are motivated by greed and fear. Behavioralists would disagree and suggest investors, and through them markets, aren’t driven by greed and fear but by humanity’s drive to accumulate pride and shun regret. It just comes out as greed and fear.

Pride is a mental process associating success with skill and repeatability– the hunter who bagged a gazelle believed he wasn’t lucky. He believed himself masterful. More important, he believed he could repeat it. By writing this book, I too am displaying pride accumulated over a career span where I don’t want to believe it was all just luck– that I was the guy flipping way too many heads for way too long. Who wants to believe that? The natural tendency of humans is to want to think success was because of skill and repeatability– not luck.

Think about your own behavior after buying a stock that went up. Maybe it went up a lot. Maybe you bought Apple in 2002 after your 12-year-old begged for an iPod. Did you pump your fist in the air? Did you congratulate yourself? Did you brag about it to your colleagues, spouse, and father-in-law? More important, did your success make you feel like you could do it again? “I bought it. It went up. I’m smart. Want to see me do it again?” Just like the hunter.

Regret is a process denying responsibility for failure– attributing it not to lack of skill but usually to bad luck or victimization. The gazelle-less hunter isn’t a bad hunter. He is just the hapless victim of poor circumstances. He’ll kill a gazelle next itme. “I bought it. It went down. The broker sold it to me. He’s the problem.” Or, “I bought it. It went down. The CEO was a crook.” There are many ways to do bad luck victimization. “I wouldn’t have bought it if my wife hadn’t been ragging on me that morning.” The mind-set isn’t, “I bought it, it went down, I don’t know how to do this so I better not do it again.” Or, “I better get some lessons so I know how to do this better.”

If the hunters didn’t accumulate pride and shun regret, they would have become despondent over failure. They would have given up hunting giant beasts as a fool’s errand. Their brains had to function this way to forage enough food to pass their genes. It is a motivational tool. If a hunter became beset by regret and ultimately depressed, those benefiting from his future potentially lucky hunting would have starved and died, and that isn’t such a good way to perpetuate the species. Accumulating pride and shunning regret were basic to our ancestors’ survival. That was necessary then, and we still do it– motivating ourselves to keep trying.

But in modern times, these behaviors cause investing mistakes. Suppose Bill owns a stock that rises 40 percent. Bill was smart to have chosen such a stock. He is a savvy stock picker, and he believes he can do it again– he accumilates pride.

Then his stock dorps 10 percent. He feels the loss about two and a half times as much as the gain, and disregards the fact that overall he is still up 26 percent. The sudden drop causes pain he wants to avoid, so he shuns regret. He believes he was just unlucky on this 10 percent drop because previous pride accumulation convinces him he can and will succeed overall. He considers selling while he can. He concludes the stock will fall further and loses sight of his long-term goals, focusing only on the short-term and acts to minimize potential short-term pain. He sells the stock and protects his ego for another day of hunting. But the stock bounces back and goes to new highs. He chooses to ignore that because acknowledging it would caust too much pain and ignoring it shuns regret nicely.

Regret causes Bill to avoid pain by taking action– selling at a temporary relative low point. Pride prevents him from analyzing his behavior accurately so he is doomed to repeat this vicious cycle. Loss aversion causes investors to buy high and sell low– which is a pretty stupid strategy.
Credits: This article is extracted from The Only Three Questions That Count by Ken Fisher (Wiley Finance, 2007).