Why do we sell our winners and hold our losers?
The average investor sells his winners and holds his losers believing they will turn around!
This phenomenon even has a name
It's called the disposition effect.
And they even conducted a study to prove it…
In 1998, two US Finance Professors Brad Barber and Terrance O'Dean conducted a study called The Behaviour of Individual Investors.
They analysed the trading activity over the period 1987 to 1993 of 10,000 households with accounts at a large discount brokerage firm.
They found, when an investor sells shares, he has a greater tendency to sell shares of a stock that has risen in value since purchase, rather than one that has fallen in value. And the worst part, investors will bank their winners at about a 50% higher rate than their losses.
Two US Professors Mark Grinblatt and Matti Keloharju also examined the disposition effect using the trading records for virtually all Finnish investors during 1995 and 1996.
They found that investors have a tendency to hold onto losers.
For instance, a stock with a capital loss of up to 30% is 21% less likely to be sold; A stock with a capital loss in excess of 30% is 32% less likely to be sold.
However, stocks with high past returns or trading near their monthly high are more likely to be sold.
Why is this?
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Emotions drive our decision!
Your emotions play a huge role in how you invest and what you invest in.
For example, you may hold onto a company that resonates emotionally with you, even if you’re losing money.
Another way emotion influences the disposition effect is, if most of your shares are in positive territory, you’re more likely to want to cash in the returns as quick as possible – Just in case you lose out.
Yet you’re more likely to hold out on your losers, just in case they bounce back.
The consequence of this is that all the gains of your winners can easily be shed by holding your losers longer!
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So what can you do to avoid the “disposition effect”?
1. Don’t sell stocks without a very good reason
Price declines are not a good reason. When a stock’s price declines, you can buy more at a better price. But always make sure the underlying business and more importantly, your investment case is still the same.
2. Always have an exit strategy
A trailing stop loss is the ultimate way to not only protect your portfolio from major crashes in the stock market, but also to protect the gains you’ve already received. Usually a 25% stop loss is appropriate for long-term investors.
3. Do nothing
Warren Buffett’s right-hand-man Charlie Munger is known for his strategy of “doing-nothing” – It involves buying profitable long-term companies with a strong brand value and ignoring what the media says in times of crisis. By doing this, you won’t panic and sell your stocks in an instant.
See you next week.
Josh Benton, Real Wealth