If you want to be a successful investor, it's vital to keep your losses small. We all make mistakes none of us can predict the future. But once an investment has gone bad, you have to cut it loose before it eats up the profits you've made elsewhere in your portfolio.
That sounds like it shouldn't be too hard, yet it's in fact one of the toughest things for an investor to do. In a 1998 study, Professor Terrance Odean at the University of California, Berkeley, found that we are 50% more likely to sell winning stocks to bank a profit than dump losers to avoid further losses. This gets expensive US fund managers who were reluctant to dump losers underperformed their more ruthless peers by up to 4% a year.
But why are we like this? And how can we overcome it? In his latest book, Thinking Fast and Slow, Nobel-prize-winning economist Daniel Kahneman identifies three psychological traits that let investors like you and I down.
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Overconfidence
Confidence is a great survival attribute. Confident people are more likely to be chosen as group leaders, more likely to attract a mate and, as studies show, more likely to be promoted and get pay rises. But there's a fine line between confidence and overconfidence, and we often cross it.
The majority of people believe they are above average drivers, for example, even though by definition this isn't possible. Perhaps the biggest mistake caused by overconfidence is the belief that we can't be wrong when we make investing decisions. Even if things don't look good for one of our stock picks in the short term, we think we will be proved right over the longer term. This stops us from selling underperforming shares. Instead, we try to find ways to confirm that our thinking is not mistaken.
Confirmation bias
This is a tendency to pay attention only to information that backs up our view of the world. Stockmarket bulls will pay attention to good economic news, or interpret bad news as meaning that central banks will print more money, which in turn will be good news for stocks.
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Stockmarket bears will heed only the bad news, and treat good news as temporary. This habit is even more damaging when we apply it to troubled holdings in our own portfolios. Rather than sell a stock, we look for evidence that the price dip is due to one-offs'. We may even pile good money after bad and buy more on the dips' to show how right we are and how wrong everyone else is.
What we don't easily do is admit that the facts have changed and our rationale for buying has simply been proved wrong. Worse, if we never admit to mistakes we can't learn from them, a rule that applies in investing as much as any other area of our lives.
Anchoring
A third psychological flaw that stops us from selling when we should is a tendency to be swayed by irrelevant numbers. In a rather alarming study quoted by Kahneman, experienced German judges were asked to read a detailed description of a woman who had been arrested for shoplifting. They were then asked to roll a pair of dice. The dice were loaded to land on either three or nine. The judges were then asked whether the sentence they would give was higher or lower than the number on the dice, and asked for how long the woman should be imprisoned.
Those who rolled a nine went for an eight-month sentence on average, and those who rolled a three chose four months. In other words, intelligent people, acting within their field of expertise, had been heavily swayed by a random anchor.
In investing, the classic example is our tendency to fixate on the price at which we bought a share. No one wants to lose money so we'll hang onto poor stocks in the hope of breaking even. Sometimes we'll even sell if we can just recover our losses. Yet this makes no sense there's no inherent reason for the share to return to the price at which you bought it. You should spend your energy looking at whether your investment case still stands, rather than hoping to get back to zero'.
Wasting time wastes money
This doesn't just apply to catastrophic losers. If you have long-term underachievers just sitting there, going nowhere, you should ask yourself why. Every day that your money is locked up in a poor performer you suffer an opportunity cost (as economists rather grandly call it) the chance to be earning a better return elsewhere. So don't think that not selling a mediocre stock is a free ride. It's better to bite the bullet and move on.
What you can do about it
There are three ways you can fight back against your reluctance to sell. The most mechanical is a stop loss or a trailing stop loss. This forces you out of losing stocks once they drop a certain distance. Picking the stop level can be tricky in volatile markets you want to avoid being kicked out of winners too early but it's an effective way to make a difficult decision automatically.
Alternatively, ask yourself: would I buy at today's price? If not, then surely you paid too much in the first place, and should sell now. Thirdly, when you buy any investment, write down your reasons for doing so. This is a good habit to get into as the sheer effort of having to think and then put pen to paper reduces the risk that you are just taking a lazy or speculative punt when you buy.
But there's another reason to do it it means that when you review your portfolio later, you have a concrete reminder of why you invested. Ask yourself whether your original buying criteria are still valid. If not, it's probably time to sell.
