"When you buy and hold, you don't have to use a death grip," as Jason Zweig puts it in the Wall Street Journal. Sometimes an investment just goes wrong, and it's better to cut your losses and get out. But that's easier said than done. A study by Berkeley professor Terrance Odean showed that the average investor is 50% more likely to sell winners to bank a profit, rather than dump losers to avoid further losses. Yet basic maths shows this is a mistake. If you buy a stock for £100 then hold as it falls by 90% to £10, you then need it to rise by 800% just to get back to evens.
What stops us from selling?
The trouble is, this irrationality feeds off itself. The higher the losses mount and the longer you've held a stock, the more likely you are to keep holding. Columbia University psychologist Eric Johnson argues that this is because "thinking about the pain a stock has caused can emotionally block thoughts about the benefits of selling it".
Then there are what Zweig calls "prisoners of the past". A good example are those UK homeowners who, as The Independent's Laura Howard puts it, suffer "brickor mortis". Last summer the average house cost about 10.5% more than it does now, according to the latest Nationwide data. But an owner who grimly clings to a property, hoping that prices will recover and ignoring how the market has changed since they bought, will just incur further losses.
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People also avoid selling, says Cornell University's Thomas Gilovich, because they tell themselves that, "if I sell, and it goes up, I'll kick myself". That fear is strong enough to overwhelm evidence that suggests prices will fall further. All these examples really boil down to one issue: the fact that hanging on in hope is psychologically much easier than admitting a mistake. So how can you override your instincts?
Think positive to boost returns
"Think about possibilities rather than pain," advises Johnson. In other words, focus on the stocks you are going to buy and look on the losers you sell as a useful source of investment capital.
Another technique to "cheat" your brain, says Zwieg, is to "reprice". So, if you bought Citigroup three years ago for $43.50, he suggests dividing by ten to get $4.35. Now imagine you had paid $4.35 a share and compare that to the current share price of about $18. Is Citigroup worth roughly four times your newly-revised purchase price? If you still can't justify buying, forget you ever paid $43.50 it isn't coming back and sell.
Use trailing stops
If thinking differently sounds a bit too new-agey, then you could try a more practical system that requires very little thought and automatically weeds out
losers: the "trailing stop". This allows you to buy shares and benefit if they subsequently rise, safe in the knowledge that you will only take a hit for a specified percentage of any share-price fall. One option, the traditional "stop" orders offered by most brokers, will trigger a sale once a share moves to, or beyond, a specified price. So, for example, you could buy Tesco at, say, 380p and set a stop-loss order at 280p. That means should the share drop sharply to, or below, 280p, your holding is automatically sold, capping your maximum loss at exactly 100p per share (380p-280p) if you have requested a "guaranteed stop". However, you get better protection from a "trailing stop".
The first thing to decide on is the selling trigger level. This has to balance the need to cut losses before they get too big against the risk of paying too much commission if you set the trigger too low and end up constantly selling stocks you have only just bought. Or, worse, selling promising long-term shares too quickly because of short-term volatility. Investmentu.com's Alex Green suggests you pick 25%. Say you buy Tesco at 380p with a trailing stop set at 25%. That means your share will be sold should the price fall to, or below, 285p. But let's say the share price rises to 440p the next day. With a standard stop order at 285p, you will only be closed out should the price then fall to the fixed trigger point, a drop of 35%. But with a trailing stop, the trigger is automatically moved up to 330p (0.75 x 440). So even if Tesco plummets at any time, you will have protected a decent chunk of your previous gains because the most you can lose is a fixed 25% of the latest price.
How to set it up
Unfortunately, currently few UK brokers offer trailing stops. Selftrade.co.uk allow you to set one for losses of between 5% and 15% as part of their standard dealing charge of £12.50 per trade. But in a volatile market that's quite a narrow range. So a better bet might be an online account with Barclays Stockbrokers, where the trailing stop trigger level can be set much higher (but needs to be refreshed every 30 days). There is no extra charge for this service, although at the moment it is only available for UK-listed and Aim shares, not overseas shares or exchange traded funds.
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