If you have ever made pancakes you know this to be true. The first pancake usually goes to the bin. Or a super hungry kid. Or a dog 🙂
I am not sure why this but it seems to be a law of nature that the first pancake will either be not done enough or too done.
What’s really interesting is how we react to this.
Everyone just seems to accept the fact that to get a stack of perfect pancakes, you need to screw the first one up 🙁
With pancakes, we accept failure as the first ingredient to success.
BUT when it comes to investing…WE react completely differently.
Heaven forbid that we have a stock in our portfolio that shows a loss!
Investors will focus obsessively on one investment that is losing money even if the rest of the portfolio is in the black.
This behavior is called loss aversion.
Investors have been shown to be more likely to sell winning stocks in an effort to “take some profits,” while at the same time not wanting to accept defeat in the case of the losers. Philip Fisher wrote in his excellent book Common Stocks and Uncommon Profits that, “More money has probably been lost by investors holding a stock they really did not want until they could ‘at least come out even’ than from any other single reason.”
It also doesn’t help too that we tend to feel the pain of a loss more strongly than we do the pleasure of a gain. It’s this unwillingness to accept the pain early that might cause us to “ride losers too long” in the vain hope that they’ll turn around and won’t make us face the consequences of our decisions.
We refuse to eat burnt pancakes and make no hesitation to throw them out and so too we should refuse to hold a losing stock position.
And if you think that hiring a professional money manager saves you from such mistakes, I have bad news for you. A couple of white papers by Barberis and Thaler (2003) and Shefrin (2000) find that professional money managers are far from immune to these biases. They are human after all.
And this leads us to the big reason that we use a systematic, rules-based process for our investing.
Rules based investing helps eliminate human emotion and the negative impacts of human behavior.
By consistently applying the same rules over and over, we can quantify our probability of expected outcome.
We know that there will be some “burnt pancakes” along the way. But we also know that the quicker we are to get rid of them the sooner our plate is stacked with “perfect pancakes”.
So the next time you are staring at your portfolio, remember the “first pancake rule”.