Why do people tend to keep losing investments, and sell the winning ones.
“Cut your losses (short) and let your profits run”.
This is probably the best known Wall Street adage. It means that the investor should get out of a position as soon as he/she realizes that it was a bad choice and should instead keep the good ones running.
But anyone who has ever invested in the stock market (or in any other financial market) knows very well that the human nature is just the opposite. We tend to sell profitable investments very soon and to leave losing investments open. When faced with a paper profit we fear having to regret we didn’t realize at that moment that the profit would turn into a loss. In presence of a paper loss, on the contrary, it is very tough from a psychological point of view to abandon the hope of making money on that position (or at least to break even).
Bias loss aversion (1):
Kahneman and Twersky in their Prospect Theory showed that, when making choices under uncertainty, people are more sensitive to losses than they are to gains (usually by a 2:1 factor).
Loss aversion bias makes the investor risk-seeker when dealing with losses (meaning that he will accept the risk of losing more if there is a possibility to recover the loss) and risk-averse when dealing with gains (meaning that he will be tempted to lock in profits in order to avoid the possibility that market turns and the profit becomes a loss).
This mechanism will cause the investor to sell the good investments (with high potential returns) and to keep the bad ones (that are likely to generate more losses). The result will be a suboptimal portfolio characterized by higher risk and lower potential returns than the original portfolio.
Investment strategies, Inbestme’s Scope :
What could an investor do to overcome this potentially harmful behaviour?
People should try to forget the price they originally paid for that investment. The initial price in fact tends to become a reference point that “anchors” all our future decisions. When we make an investment, we open a mental account for that single financial instrument, segregated from the other components of our portfolio and whose reference point is the initial price. This single mental account is subject to the same loss aversion bias that we mentioned earlier on, no matter what is its interaction with the other investments. We hate closing a mental account at a loss as this causes pain and regret.
We forget that money is fungible. If we realize that we made a bad choice instead of just hoping it is better to react and put our funds to work into a more profitable idea. It will be easier to recover losses riding a better horse. An investment should be kept only if it still makes economic sense.
It is often said that the best traders are not those who are always right (which is impossible), but the ones who are the first to admit that they were wrong and to look for a more profitable trade without having their ego being beaten by the fact of taking the loss.
Inbestme recommends a long term investment strategy (specially in our customised portfolios). Is this coherent with what we just said?
Yes, because being an intelligent long term investor does not mean stubbornly holding on choices that have proved to be wrong but it rather means holding on good investments no matter what the emotion-driven market does in the short term.