There is a big problem many stock investors face. Should I sell my winners? Should I cut my losses or wait till my stocks bounce back? There’s a common tendency among investors to sell winners rather than hold on to them. It’s also common for investors not to sell stocks which are losing value, hoping they will bounce back. This brings us to the famous saying by Ben Graham “The investor's chief problem - and even his worst enemy - is likely to be himself.”
Many stock investors sell their winners and hold on to losing investments for too long. This is called the “Disposition Effect.” What is the disposition effect? This is nothing but an artificial headwind. (For those who don’t know what’s a headwind, it’s the wind which moves in the opposite direction to an aircraft, slowing its speed). When there’s good news for a particular stock, the stock price doesn’t rise immediately. This is because a lot of people sell this stock and many people don’t buy in spite of the good news.
Similarly when there’s bad news, the stock price doesn’t fall immediately as many investors are reluctant to sell and hold on to their losses. This brings predictability in stock returns.
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The great fund manager Peter Lynch says that selling winners and holding onto losers is like cutting flowers and watering weeds. Take the disposition effect which results in small gains and huge losses. You get inferior returns.
This is the simple rule of buy low and sell high. If stock fundamentals start to fall, it’s a good time to get rid of it. Your investment is no longer sound.
Sell the stock if it hits the target price. You set an upper limit and when your stock reaches this level, you get rid of it. You can also set a floor price. If the stock price falls, sell it at the floor price and cut your losses. If you want to rebalance your portfolio, sell your stocks and invest elsewhere. You can also sell the stocks and use the cash.
Why do you need to know when to sell shares? It’s very simple. It stops you getting blinded by paper gains (You actually sell the shares and make a profit). Let’s say a stock has done so well that it has become a major part of your portfolio, it’s time to sell it and rebalance your portfolio.
This prospect theory states that “You make decisions based on potential value of a gain or a loss, instead of looking at the final outcome.”
This theory states that people don’t like suffering losses. (They are averse to losses). They evaluate gains and losses vis-à-vis a reference point. Your sensitivity towards a loss is twice that of a gain. The purchase price of the stock is a common reference point. You would evaluate gains and losses against this reference point. According to the prospect theory, the investor has an aversion to losses and this risk-aversion makes him book profits soon.
Let’s understand the prospect theory with an example. If you are given a choice of winning Rs 500 with certainty, rather than taking a risky bet like tossing a coin and either winning Rs 2,000 or nothing. You would choose the certain Rs 500.
Similarly if you are faced with the choice of a 100% chance of losing Rs 500 or a 50% chance of no loss or a 100% loss, you would most probably choose the second option.
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Let’s say you have sold a share at a profit. This brings a sense of pride and accomplishment. You feel you have made the right investment decision. However if you suffer a loss, there’s a feeling of regret. This happens if you actually sell the share. (These are not notional losses but actual losses). You will find most investors booking profits, but rarely booking losses.
You are prompt when booking profits, the moment your stocks hit the set target. However, you don’t follow this principle when stock prices fall. You find several excuses to not sell the stocks.
Mental accounting is very common with equity investors. You must have heard of cases where players at casinos won millions of rupees and kept gambling till they lost everything and more. Why did this happen? This is because these gamblers considered winnings to be unexpected profits. They would not have blown all this money if the winnings were because of a day job.
Stock market investors behave in a similar way. They would not take risky bets (invest in risky stocks) with the money earned from the salary. However, they might take risky bets with the capital gains. This is because these investors are willing to bear higher losses on the capital gains. These profits have come easily and stock market investors are willing to take risky bets with this money.
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