There are countless studies that show how investors cling to stocks that have
declined, even though they have no confidence that they will recover. Why is
that? Considering recent history and how many stocks have recently tanked,
trying to answer this question seems especially critical now as you consider
your current positions in the market.
How often have you heard from some person at the water cooler, "I will
never sell XYZ while I live." XYZ is of course a fictitious stock. How
about, “I rode it down, I mind as well stay to ride it back up.” You
probably have heard something similar more times than you’d want. Me too.
What troubles me about these types of comments is that these
investors have, for the most part, lost touch with the principles of prudent
investing. If I were mean, I would have said they had lost touch with reality.
But I’m not. So I won’t.
The problem is that these types of investors are holding firmly on merely
because after taking a horrible loss they are waiting, hoping, that the stock
will rebound to the price at which they bought it so they can sell without
incurring a loss. This is, unfortunately, a terrible and costly mistake. And
very common too.
- The Known vs. The Unknown
In a paper published out of the University of California
at Berkeley by Terrence Odean titled “Are Investors Reluctant to Realize
Their Losses?” (http://ideas.repec.org/p/ucb/calbrf/rpf-269.html)
he discussed how investors realize their gains more readily than their
losses by a margin of two to one.
This means investors are two times more likely to sell winning stocks
than they are to sell stocks that lost big. Furthermore, he pointed out
that most
of the winners that were sold to cover losses went on to outperform the
losers that investors kept.
People are generally risk-adverse, making them extremely cautious when
it comes to an unknown factor like a stock’s growth. A loss is a known
value. I lost $17.91. I will be happy when I regain that $17.91. The concrete
nature of that number allows investors to sit on the loss because they have
a benchmark they need to attain. A gain on the other hand is an unknown factor.
My stock went up 10%. Then lost 5%. Then gained another 15%. Do I sell now?
What if it drops tomorrow? This is the type of uncertainty that makes people
uncomfortable. So they sell winning stocks after only realizing a small amount
of gain and miss out on the big gains down the road.
Losing money is a painful thing that can trigger irrational, cataclysmic
decisions, especially among less experienced investors. Many of us can still
feel the pain or are still suffering the consequences that resulted from our
euphoric exuberance from several years ago. The uncertainty, fear and even
panic that overcame many of us had a freezing effect on us. That inability
to act during what was an absolutely critical time cannot be allowed to happen
again. It is essential that when similar times return, investors act rationally
when making investment decisions.
Despite what some people claim, even the best and most successful investors
make mistakes. What differentiates them from the rest of the pack is that they
research stocks to death and thus make fewer mistakes. And equally importantly,
they quickly recognize, acknowledge, and sell off when they do make mistakes.
It seems only natural that when you realize you made a mistake you fix it,
usually by selling. But you would be amazed how often this is not the case,
especially when it entails selling at a loss.
It has to do with the ego in all of us. Nobody likes to admit to himself
that he was wrong. Nobody wants to take that long look in the mirror. If we
made a mistake in buying a stock but can sell it for even a minor profit we
feel smart and self assured. But if we take a loss, we feel sheepish and angry
at ourselves for our mistake. This is only natural but it has the possibility
to be extremely destructive to investments. It promotes investing according
to emotional whims, rather than cold, calculated thinking.
Remember, more money has probably been lost by investors holding a stock
they really did not want until they could at least break even than from any
other single reason. If you can avoid this snare, you will be better off than
the vast majority of investors. Remember again, the enemy of successful investing
is emotion.
- Cold, Calculated Thinking
Understanding that human nature makes it difficult to sell losing stocks
is the first step in removing that irrational feeling from your decision-making
process. Try this. Take a sheet of paper. Now imagine the value of all of your
stocks to be cash. And if you could buy anything what would you buy? How would
you invest this cash today? Write those things down on your piece of paper.
Now compare this made-up portfolio to what you really own. Is it radically
different? If there are any stocks you currently own that you would not buy
today consider the reasons. If you’re waiting for a recovery, sell it.
If there is a good reason to keep a stock, such as a large capital gain, then
make your decision after considering all your options and the implications.
If you don’t know the answer than ask someone, like your broker, for
help.
When you are holding onto a losing stock, don’t forget to consider this
one bit of information that should make the decision to sell easier. You can
get the IRS to pay you for selling a losing stock! That’s right! Mind
you, this is an oversimplification, but the general idea is right. Ask your
broker for specifics. Regardless, this should help ease the pain of selling
a loser.
The world turns everyday. So, too, does the market. When companies and
industries are subjected to the bizarre ebbs, flows, and crosscurrents of business,
they change. New information surfaces, washing away assumptions, making your
stocks decline—usually for a good reason. The key is to recognize whether
your hard-earned money should be elsewhere by figuring out which stocks are
mistakes and which represent opportunity. That's not easy, but it is certainly
much easier if you can overcome our basic human nature to irrationality cling
to losing stocks.
