Thinking, Fast and Slow - Selling Winners Too Early and Keeping Losers For Too Long

By The Boy Who Procrastinates - February 15, 2020

In the previous few posts, I have touched on the topics of Anchoring EffectProspect TheoryEndowment Effect and Narrow Framing in the book review of Thinking, Fast and Slow by Daniel Kahneman. 

Building on the concept of prospect theory and loss aversion, we will talk about a long standing irrationality of investor behaviour that may have investment impact on your portfolio. 

Which would you sell?

Imagine that you are presented with the following scenario:

You need money to cover the costs of your daughter’s wedding and will have to sell some stock. You remember the price at which you bought each stock and can identify it as a “winner,” currently worth more than you paid for it, or as a loser. 

Among the stocks you own, Blueberry Tiles is a winner; if you sell it today you will have achieved a gain of $5,000. You hold an equal investment in Tiffany Motors, which is currently worth $5,000 less than you paid for it. The value of both stocks has been stable in recent weeks. 

Which are you more likely to sell?

As one would expect, most respondents chose to sell Blueberry Tiles and marvelled at their profits. 

Framing the scenario as a choice between giving yourself pleasure and causing yourself pain, the decision to sell Blueberry Tiles and enjoy your investment prowess is pretty straightforward. 

Such prevailing preference for selling winners rather than losers has earned an opaque label as the disposition effect. 

Disposition Effect

Behavioral Economists Hersh Shefrin and Meir Statman offered some of the earlier explanations on disposition effect in their 1985 paperIt refers to the tendency of investors to sell winning investments too soon and holding on to losing investments for too long. 

The cause of the disposition effect can be traced to the prospect theory which posits that people experience greater pain of loss than joy of gain of comparable magnitude. 

As losses loom larger than gains, investors often hang on to battered stocks for too long in the hope that it will recover and break even, resulting in a situation known as get-even-itis. 

Similarly, this leads to investors selling their winners prematurely to lock in on the gains, for fear that the profits will evaporate if the share price were to fall back down. 

Seeking Pride and Avoiding Regret

On an emotional level, the sale of assets that have increased in value allows investors to realize gains and vindicate their astute investment decisions. 

Au contraire, closing a position at a loss induces regret and is tantamount to an admission of misjudgement. Get-even-itis stems from an unwillingness to admit that we were wrong by turning paper losses into real ones. And hope springs eternal that if we hold on just a little longer, the investment might turn around. 

The decisions to hang on to losers and sell winners are often battles between regret and pride and investors generally avoid the former and instead seek the latter. 

Selling your winners and holding onto losers is like cutting the flowers and watering the weeds.                  — Peter Lynch, One Up on Wall Street

Implication of Disposition Effect

On a personal level, the preference to realize profitable stock investments might seem reasonable to the investor, but such emotionally-driven behavior may hurt returns over time. From an investment perspective, a security's future performance is unrelated to the price at which the investor purchased the security.

It is a well-documented market anomaly that stocks which gained in value recently are likely to go on gaining at least for a short while. Research into the investment impact of the disposition effect by Terrance Odean has found that winners that were sold, outperformed losers that were retained by an average excess return of 3.4% per annum. 

A rational investor would be better off by letting profits run and cutting our losses with bad investment sooner. Instead of getting sentimental, it is crucial to be cognizant of the basic notion that stock momentum matters. 

There is no guarantee that our bad trades will get back to even. And even if they eventually do, future opportunities should not be held captive to bad decisions in the past. 

Overcoming Disposition Effect

It may be surprising to know that both groups of professional and amateur investors succumb to the disposition effect. While it is unlikely to eliminate this behavior anomaly completely, the disposition effect can be minimized through a number of ways. 

To better manage our losing investments, we have to determine whether the drop in share price reflects any change in the underlying fundamental value of the company (e.g. questionable accounting practice/snowballing of debt). If it has been caused by a black swan event such as the ongoing Wuhan Coronavirus outbreak, it would probably be wiser to hold on to them. 

In addition, we may consider asking ourselves if this investment is the best allocation of our money. If not, the rational action is to sell the stock, despite the loss, and put the money to work somewhere else. 

Ignoring the original cost can also help to reduce the anchoring effect on the entry price and offset this bias. After all, it is the current market value and future prospects of an investment that truly matter. The amount of personal investment in the stock that one has gained or lost holds no relevance. 

Personal Thought 

Overcoming the disposition effect may be easier said than done. I, too have my fair share of selling winners too early to lock in profits and keeping losers for too long in hope that it will rebound. 

Personally, I am still wrapping my head around closing positions for my investment at the appropriate time. Of course, it is definitely easier to sell winners than losers. Other than the voluntary general offer for M1, I have yet to realize my losing positions.

In any case, I strive to document my personal thesis and rationale for a particular investment in this blog. If it still holds, even with the price trending downwards, the investment is typically safe to hold on. Should the thesis be no longer valid, then it is probably time to cut and run.  

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Disclaimer: Kindly note that this is not a sponsored post. The author is in no way affiliated with the publisher/author and does not receive any form of remuneration for this post. The Boy who Procrastinates has compiled the information for his own reference, with the hope that it will benefit others as well.

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