Cut your losers and let your winners run is an old investing adage. It’s also rarely followed by investors.
Instead, investors have an affinity for selling winners. It feels good. It builds our confidence and gives us something to brag about for years.
In fact, we’d rather sell an investment that’s made money — likely continues to make money — than suffer the pain of selling a loser. So we hold onto the loser with the hopes that it breaks even.
The blunder of selling winners too soon and holding losers too long is known as the disposition effect. It’s one of the biggest mistakes investors make.
Daniel Kahneman once said that it originates with our inability to view our portfolio in its entirety. Every good portfolio is designed to meet some objectives. It lays out exactly what should go in it and why.
Of course, every portfolio is bound to have winners and losers. Nobody bats 1,000, after all. Losing is part of the game. But collectively, those winners and losers still produce a long-term return.
Except, we don’t see it that way. Instead, we tend to key into each position separately. Then we let the price paid for a stock grind away in our heads until it triggers an action. And those long-term returns suffer for it.
It speaks to the importance of having a good reason for selling (unrelated to price). Which should be tied to a good reason for buying.
Here’s how Kahneman explained it:
This juxtaposition of gains and losses on the one side and wealth on the other is interesting. Gains and losses are temporary — they are events. Wealth, on the other hand, is a state. It is a broader way of looking at things. In fact, what dominates our behavior is much more immediate than considerations of wealth. It is consideration of gains and losses. That is the essential idea of both behavioral economics and behavioral finance. A fully rational agent has a broad view – it has a long horizon. But a basic finding, well replicated in psychology and decision theory, is that people are myopic and that they weigh immediate consequences much more than delayed. There is in fact brain research that indicates that there are special brain circuits that respond to relatively immediate consequences, and other brain circuits that react to more delayed consequences, and we tend to be more rational about the more delayed consequences than about the immediate consequences.
Narrow framing, which is a characteristic of most investors’ thinking, has many manifestations. One of them – and one of the more important ones – is that people find it unnatural to take a portfolio view… They tend to follow the performance of each stock separately. Many people know the price at which they bought the stock. And knowing the price at which you bought the stock is actually a bad idea; you are much better off if you do not know the price at which you bought the stock.
It turns out that when people have to sell a stock from their portfolio, they are not rational between winners and losers. People tend to sell winners and hang on to their losers. The psychology of that is quite straightforward. When you sell a stock on which you made money because you sell it for more than you bought it, then in effect, you score yourself a success. When you sell a stock for less than you bought it, you acknowledge a failure. When deciding to sell, people have control over whether to give themselves pleasure or give themselves pain, and they tend to give themselves pleasure. In other words, they tend to sell winners and hang on to losers. It turns out to be a bad idea. This is a significant difference, and a significant part of the 3.4 percent of the cost of individual ideas.
In any diversified portfolio, there will be both winners and losers, and the consideration that should determine which you should sell, if any, is certainly not the price at which you bought it originally. So, a rational investor trades less, much less than real investors do, and would also trade differently: would buy different stocks and sell different stocks.
Source:
The Psychology of Investors
Related Reading:
Daniel Kahneman: The Most Important Bias
Daniel Kahneman: Loss Tolerance
