Here is a piece from NYT.
The Psychology of Selling Losers
By MARK HULBERT
fter a coin comes up four heads in a row, what will happen on the fifth flip? Many people mistakenly say the
odds strongly favor its coming up tails, because, they figure, tails must be overdue. In fact, of course, the
coin doesn't remember its previous flips. The odds of its coming up heads are always 50 percent, regardless of
what happened before.
Investors often make a similar mistake when choosing which stocks to sell: They base their decisions on whether
they're holding a stock at a profit or a loss. But just as with the coin, that's irrelevant: Whether that stock is a good
investment for the future has nothing to do with the price at which they bought it.
Consider Amazon.com. Is it a good investment today at $101.875 a share? Analysts have widely different opinions
on the issue, and few can agree even on which factors to consider. But one thing certainly has nothing to do with
Amazon's prospects: Whether a particular investor bought it earlier this year, when it was trading at more than
$180 a share (and are thus holding it at a loss), or instead bought it 12 months ago, when it was trading near $10,
(and thus have a handsome paper gain).
Many investors don't see it that way. Extensive research has shown that they are more likely to sell Amazon, or
any stock, if they are holding it at a profit than if they're holding it at a loss. Known among researchers as the
"disposition effect," this behavior can cost an average active investor thousands of dollars a year.
An extensive study of the disposition effect was conducted recently by Terrance Odean, an assistant professor of
finance at the Graduate School of Management at the University of California at Davis. Odean tracked the trading
histories of 10,000 individual investor accounts from January 1987 through 1993. He found that instead of cutting
their losses short and letting their profits run -- two widely cited bits of portfolio advice -- the average investor did
just the opposite. Investors realized only 9.8 percent of the losses they could have realized, compared with 14.8
percent of their profits.
The reason for that behavior depends as much on psychology as it does on finance. Investors, it seems, will go to
some lengths not to sell a stock at a loss. After all, as long as they avoid selling a loser, they can rationalize that it
will recover someday, thus vindicating the original decision to buy. By contrast, once they sell a stock, investors
cannot avoid the fact that they lost money.
The reluctance to realize losses, of course, has major tax costs. Investors who choose to sell their winners, and not
their losers, must not only pay more taxes because of the capital gains, but they also forgo the deductions they
would receive for realizing losses.
Immunizing yourself from the disposition effect isn't easy because no one behaves this way as a deliberate policy.
The first step is to understand that your psychological need to avoid losses may compromise your objectivity. You
may (italics)think(end italics) there are good reasons to sell your winners and hang onto your losers, but there's a
good chance that you're kidding yourself.
You often need objective guidance to help distinguish between the cases in which you really should sell a winner
and those in which you want to sell just because you hate to realize a loss. One good source of objective guidance
is the Value Line Investment Survey.
Each week, it divides 1,700 of the country's most widely held stocks into five categories according to their
prospects over the next 12 months, based on quantitative factors -- primarily earnings and price momentum.
This service has an excellent record: it's in first place among all newsletters tracked by Hulbert Financial Digest
since mid-1980, producing an 18.2 percent annualized return, versus 16.8 percent for the Wilshire 5000 through
1998. Because it is completely objective, its advice on a stock cannot be swayed by the disposition effect.
Mark Hulbert is editor of the Hulbert Financial Digest, a newsletter based in Alexandria, Va. His column on
investment strategies appears every other week. E-mail: strategynytimes.com. |
