I have written about it numerous times, but it is a point worth repeating and reiterating that is –
An investor’s psychology will likely influence their portfolio returns more so than the financial analysis they perform.
With this in mind, I am focusing in my current articles on the significant and various psychological traps investors and traders fall victim to. Often, without even realizing, they have done so. It is these that are the most insidious. It is one thing to know you lost money because of a bad investment decision that you made. But to lose money and not even be aware of the psychological traps that were at play is something else all together.
Loss Aversion – Trying to avoid losses can end meaning you lose big time!
No one likes to lose, this is no great revelation. From the time we are in early schooling we quickly learn that losing = bad, winning = good. Society teaches us that being wrong or losing is an emotionally undesirable occurrence. Because of this, we are powerfully shaped by psychological forces that unconsciously push us away from situations where we may experience loss.
Most of the time, this is a good thing and serves us well. However, when it comes to investing, this psychological program can often cause more problems than it avoids.
A situation where this shows up in investing when the cries of the market, the media, commentators, society etc. are that the stock market is a terrible place to put money, that a bear market is happening/bull market is about to collapse.
U.S. Financials – Where many an investor has lost big time!
U.S. financials is a sector where many people have been a victim of Loss Aversion. Owing to the big losses experienced because of the Global Financial Crisis (GFC), many investors are reluctant to invest in this sector. This fear is explained and justified by many commentators as being prudent because of the broader macroeconomic environment (sluggish GDP, housing still struggling etc.).
I believe these explanations are merely justifications for the actions people have already taken that is, sold out. Not wanting to experience the stress and loss they went through in 07-08, many investors have thrown the towel in with regard to investing in the U.S. financial sector. Even the mainstream commentary is bearish and skeptical. Earnings that are positive and growing are announced, yet they are discounted by commentators as unsustainable.
It is my suspicion (and hence investment thesis) that due to overwhelming sentiment that the majority of the U.S. Financials are doomed, and investors are fearful of losing capital in them that they, in actual fact, represent a great buying opportunity.
Few people are out in the investing world singing the praises of the financial sector. This leads me to think that the bullish sentiment for them is very limited and mute. Consequently, the current buying pressure is for naught. To me, this means that in time the likely movement in buying pressure will be to increase (as let’s face it, the pressure at the moment is quite lackluster).
For me, three companies stand out as good buying opportunities.
First of all is Bank of America Corp (NYSE:BAC). At its peak prior to the GFC, Bank of America was trading at over $50 per share. In the aftermath of the GFC, Bank of America collapsed to a low of just over $3. Losing 95% of its value in just a few months is a tough pill for most investors to accept. Now, at $12 a share, I feel that the great majority of investors are still waiting on the side lines to see if it falls over again, because they all ‘know it will collapse.’
Something I find interesting is that many ordinary investors see Bank of America Corp (NYSE:BAC) and say ‘I can’t believe that Bank of America was trading at over $50 a share and in just a few months it was obliterated down to just $3!’ Few recognize that yes whilst that is true, it also moved from $3 to $18 a share in 2009 in virtually the same time frame it took to collapse. Smart and calculating investors had the potential to pick up nearly 5-fold gain.
Currently trading a Price to Book Value 0.59, I think Bank of America offers exceptional value. I believe Bank of America Corp (NYSE:BAC) will continue to perform decently. I am not expecting bumper profit growth. If it can just maintain earnings, then over time, investors will gradually reprice the stock. Repricing the stock to a Price to Book Ratio of 1 will see Bank of America trading around $20 (about a 75% gain from current prices).
To me, this represents a good investing scenario, one though I think many will miss out on because of the influence of Loss Aversion. Most investors will look at Bank of America Corp (NYSE:BAC) and see the huge losses they took during the GFC rather than evaluating it for the potential performance of it in the future.
I see a similar situation emerging in Citigroup Inc. (NYSE:C). Currently at $45, Citigroup is trading at a P/B of just 0.72.
My view is that Citigroup has had 5 years to restructure and write down the toxic after effects of the GFC. Citigroup just announced their quarterly earnings with good profit growth. I think that investor sentiment towards Citigroup is still bearish, with many people still believing that in the world of slow growth, mega-banks such as Citigroup will struggle. With billions of dollars of idle cash sitting on its balance sheet, Citigroup is positioned to take advantage of the opportunities as they arise.
It is important to remember that even if earnings don’t grow, and Citigroup Inc. (NYSE:C) just maintains current earnings, it is still trading at a significant discount to Book Value. Over time, as the fear whatever the next ‘crisis’ will be fades, we can expect Citigroup to be repriced back towards a Book Value of 1. This would offer a gain of approximately 36% from current levels.
If there ever was a company that engendered the feeling of wanting to avoid losses, it is American International Group Inc (NYSE:AIG). After having wiped out virtually all of the equity common shareholders had in the company, AIG has possibly removed entire sections of the investing community from ever wanting to invest again! The losses many experienced in owning AIG were truly breathtaking.
However, time waits for no man, and the world keeps moving forward, even if the psychology of investors doesn’t. With a current Price to Book Value of 0.58, I believe American International Group Inc (NYSE:AIG) represents excellent value. As with Bank of America and Citigroup, AIG doesn’t even need to grow its earnings but just maintain them and have the market believe in their sustainability.
Should the market do this, and remember time heals all wounds, American International Group Inc (NYSE:AIG) might be repriced over the next few years to a Price to Book Value of 1. This would translate into a gain of some 75% based on today’s stock price of $39.
With an understanding of Loss Aversion, I look for stocks that I believe are fundamentally sound, yet are viewed by most investors with disdain. This disdain creates a temporary disconnect between price and value. I believe these three stocks fit this mold. I expect to see the market shift its view towards them over time, and for my portfolio to be the recipient of gains as the Loss Aversion most investors are currently gripped by fades.
The article Why Loss Aversion Can End up Costing You Big Time originally appeared on Fool.com and is written by Jarrod Bailey.
Copyright © 1995 – 2013 The Motley Fool, LLC. All rights reserved. The Motley Fool has a disclosure policy.