A common poker mistake may shed light on how stocks will finish off the year

Robert B. Stanton | Getty Images

It's been a long night of poker for you.

After a solid start, you've gotten huge sums stolen away by terrible twists of fate. Then things turned around, and a big beating became a small win. You're looking to leave after a few more hands, when a marginal spot comes up — the type of situation that can mean a substantial gain or a significant loss but will depend more on the coming cards than anything else. You might make money on average, but you'll lose about as often as you'll win.

Will you take the risk? Or will you fold away what you've got, cash in your chips, and call your significant other to say you've left the casino a winner?

If you're like most players, you'll take the opportunity to "book a win." And if you're an investor who has endured a wild ride in equities this year, you might choose to do the same.

This behavior probably isn't rational, at the poker table or in the market. But to the extent that a large group of investors choose to metaphorically cash in their chips, the market may be unlikely to see substantial gains in the final trading days of the year.

In finance, this predilection to close out winning trades and hang on to losers is known as the "disposition effect," and it is a consequence of what economic psychologists Daniel Kahneman and Amos Tversky call "loss aversion," whereby people go to unreasonable lengths in order to avoid losing money.

As the final days of 2016 tick off, one could see how closing up shop would be appealing for many investors. Large-cap stocks started off the year with a horrifying slide, logging the worst start to a year ever. Yet equities came back from the brink, turning out a respectable performance by autumn, despite the anxiety over the presidential election. Then, just as all appeared to be lost following Donald Trump's win and S&P 500 futures fell nearly as much as they were allowed to in the overnight session, the unexpected happened: A huge rally broke out, taking stocks to breathtaking new heights.

With Christmas around the corner, volume is drying up, and the market has essentially come to a standstill. In the five sessions since Dec. 14, the has failed to trade either below the low or above the high it made on that day. On both Tuesday and Wednesday, the large-cap index's high was less than a third of a percentage point above its low.

And despite lingering hopes of a late "Santa Claus rally," investors' propensity to book a win on the year might mean that no big surge is around the corner.

Win-booking may be pleasing to our caveman brains, but to be sure, passing up good opportunities in order to finish a given session in the green makes little sense. As professional poker player Andrew Brokos has written: "A 'session' is an arbitrary length of time. Your entire career playing cards is one long session, and your goal should be to be up as much as possible."

For some, there's nothing arbitrary about annual performance. Many active managers will find printing an attractive yearly number an unparalleled way to keep existing investors happy and coax new ones to join in. And from a practical perspective, fresh capital does tend to be deployed at the start of months, and particularly at the start of years.

But for those not bound by such constraints, failing to invest money just because one does not want to jeopardize a good 2016 is indefensible. Stocks can always drop, but if one thinks equities are a better pick than cash for one's money, then into stocks that cash should go. A year, like a session, is an arbitrary length of time — and one will obsess over booking a short-term win to the detriment of one's long-term financial well-being.

Just don't be surprised if, in these last days of December, your fellow buyers prove to be few and far between.

Related Tags