Money market savings account. Spin Control for Yourself
Nassim Nicholas Taleb, my friend, and the author of Fooled by Randomness, tells a story about one of his former clients. A Swiss firm hired Nassim's firm to put on a hedged position. The trade involved one Swiss camebymaking more onth e non-Swiss investment t
The bet went on for some time, and it was very profitable. The clients, however, were not happy. They were making money overall, but the gain came by making more on the non-Swiss investment than they were los ing on the Swiss investment. In cartoon terms, the payoff to the trade looked like: Swiss investment LOSS Non-Swiss investment GAIN Total: GAIN
Seeing the loss, particularly on the Swiss investment, ate away at the clients. Nassim tried to explain that the important thing was to make money overall. Nothing worked to assuage the clients until Nassim started just reporting the position as:
Now the client didn't have to see that offensive "LOSS" and was happy. This may seem silly, but Professor Richard Thaler has shown that most people exhibit some form of this irrationality in what he calls mental accounting. 17 We might, for example, be willing to borrow money on our credit cards at 18% while keeping a money market savings account that earns 2%. A rational investor wouldn't keep such separate accounts, but rather would pay off the credit card debt with money in the money market savings account.
Even when there are no real accounts, people tend to keep separate mental accounts for their money, and this can create costly irrationalities. For example, I was out one evening shopping with Patricia. She found some costly cosmetic cream at the swanky store called Sephora. The cream cost $135 for a small tube.
"Are you going to buy the cream?" I asked. Patricia said yes, but then added "I've spent too much money today. I'll come back tomorrow morning and buy it." Patricia kept a mental account for each day's spending. This informal accounting system caused her to spend extra time, use extra gas, and pay an additional parking fee to acquire what she could have purchased immediately.
Like all people, I tend to maintain mental accounts, and it has hurt my investment performance. Beginning in early 2002,1 started buying stock in some gold mining companies. I thought that the Federal Reserve's easy money policy might lead to a rise in gold prices, which in turn would increase the profits of gold mining companies. Accordingly, I invested a small amount in these stocks.
How did I do on my gold investment? Since my initial purchase, the price of gold has risen by more than 50%, and many gold mining stocks have doubled. So I was absolutely correct with my decision to buy gold. Unfortunately, I made absolutely zero on my investment.
Why did my trading so completely fail my analysis? The answer was that I was buying gold stocks in an account that had nothing else in it except for some inflation-protected bonds. Gold mining stocks can be pretty volatile. So whenever gold declined, I saw this account shrink dra matically in value. This made me feel like an idiot, and I tended to sell the stocks at exactly the wrong time.
I was suffering from a form of mental accounting. Gold is a hedge against inflation. Most of us will be far better off in a world where gold prices are low. So in periods when gold was dropping, my prospects were improving. When gold went down in price, my overall position looked like:
So I should have been happy when gold went down. The solution for me is the same as the solution for Nassim's clients. I now make sure that I look at my overall position. In the past, I had tended to look at each account separately. Now I force myself to use financial software to look at my total position.
So the lesson is we need to perform some "spin control" even for our selves. We have to guard against goading our lizard brain to become active (and destructive). That means we should anticipate what sort of information would push us toward emotional decisions.
Conclusion: Look at your financial position in an aggregate fashion. In particular, be sure to combine any defensive positions with other investments that are being protected.