Most investors are too early to sell their winning stocks and too reluctant to let go of their losing stocks. This tendency is more pronounced when people get fixated on the stock price alone and forget about the quality of the underlying business.
I remember this conversation I once had with Ashish, my ex-colleague, a few years back.
“Man, stock market is too risky.” Ashish shook his head.
“What makes you say that?” I quizzed him.
“I bought DLF stocks in 2008 for 1 lakh, and now they’re down by 90 percent. But my DLF flat appreciated by 20 percent in the same time. Such an irony that it’s the same company where the stock is a loser, but their product is profitable. I sold the flat recently.” He said.
[show_to accesslevel=’almanack’] “Great! What about the DLF stocks? Did you sell that also?” I asked him.
“No, I am waiting for the price to come back to my buying price.” Ashish reasoned.
“What makes you think that the stock will come back to your buy price?”
“I don’t know but I can’t sell it and book the losses. I hope I recover my initial investment at least.”
Ashish was making the same mistake that thousands of investors do all the time. They water their weeds and uproot the fruit-bearing plants. In investing circles, this bias is known as Disposition Effect.
Disposition effect is the tendency of investors to sell those investments whose price has increased while holding on to those that have dropped in price.
I was once talking to a participant in Safal Niveshak’s value investing workshop. The gentleman sheepishly disclosed his master investment plan.
He said, “I’ll buy a stock and when it doubles, I’ll sell half of it. That way, I’ll recoup my initial investment, so essentially the stock becomes free for me. Any gains on the remaining half after that is pure profit and I would have covered my downside also because the initial investment is already cashed out.”
Superficially, the logic seems intelligent. However, the argument holds only when you have invested in by looking at the stock price and have no idea about the quality of the underlying business. And without knowing the fundamental strength of the business, how can you ensure that you’ll have the patience to wait till the stock doubles?
As you can see, Disposition Effect is powerful when the investor’s eyes are fixed on the price.
The primary reason behind this mistake is that humans are wired to minimize losses. It’s called loss aversion bias. Daniel Kahneman won a Nobel prize for his work on prospect theory which essentially deals with loss aversion. The theory of loss aversion states that losses have more emotional impact than an equivalent amount of gains.
So, when investors see a notional loss on their stocks, they find it difficult to sell those stocks for selling will convert those paper losses to real losses.
The need to be proved right is another reason why most investors are in a hurry to sell their winner and reluctant to sell the losers. This is also known as regret aversion. When people fear that their decision will turn out to be wrong in hindsight, they exhibit regret aversion.
Holding on those stocks which have gone down from the purchase price isn’t a problem unless the underlying business is still doing well. But most investors get fixated on the price itself and ignore the fundamentals of the business.
Recently, I was listening to Mohnish Pabrai’s (an accomplished value investor) interview where the host asked him about his investing mistakes and he said that many of his 10-bagger stocks turned out to be 100-bagger but he sold them too early and couldn’t ride the 100x gain all the way. If an investor of his stature can fall for this bias then a normal investor like you and I should be supremely careful.
One of the best investment advice that I once heard from Warren Buffett’s mouth was that the buying price of a stock should never be a factor in deciding when to sell the stock. Once the stock has gone into your portfolio, you should ideally forget about your buy price and keep your gaze fixed only on the intrinsic value and the business quality.
Disposition effect is hard to fight however there’s a mental trick that can help you. It’s a thought experiment called mental liquidation. Prof. Sanjay Bakshi explained this idea in his interview with Safal Niveshak. While talking about how to deal with value traps, he said –
“The first thing to do is to recognize it (that value traps exist). Many people find this hard to do. They go into denial. If something you bought has gone down 50%, something is wrong either with the market or maybe something is wrong with you. And it’s not a good idea to assume that the market is wrong. It’s often wrong, no doubt, but not always. Look at the fate of folks who bought into DLF, Unitech, Lanco, Rcom, and Suzlon in Jan 2008 and who are still holding those stocks. Here are the stock price returns from 1 Jan 2008 till date (July 2012): Lanco: -85%, DLF: -80%, Unitech: -95%, Suzlon: -95%, RCom: -93%.
People, who held on to these names since 1 Jan 2008 – at some point, they went into denial. They kept on inventing new reasons to own these stocks even though the original ones were no longer valid. People need a way to de-bias themselves and one good way to do that is to mentally liquidate the portfolio and turn it into cash and then, for each security, ask yourself, “Knowing what I know now, would I buy this stock?”
Often the honest answer would be a most certain “no”. Then the next question you have to face is – “Then why do I own it now?”
You have to deliberately expose yourself to cognitive dissonance and then you have to learn to promptly resolve it. I used the above names as examples even though none of them were value stocks. But the same rules apply to value stocks, which turn out to be value traps. You have to recognise it which will expose you to cognitive dissonance, and then you have to rationally resolve the dissonance. And there is only now way to resolve it rationally – swallow your pride and sell it.”
So, whenever you have loser in your portfolio, repeat this thought experiment. Imagine that you have sold the stock and turned it into cash and then question yourself if you would buy the same stock again at the current price. If you find yourself answering “No”, then you should actually sell that stock immediately.
The second trick to fight disposition effect is something called hedonic framing.
One of the reasons behind this mistake is that we want to make up for our losses in the same way we lost it, i.e., we mentally compartmentalize each stock into separate accounts and wish to come out net positive for each account.
However, investing is a game of probabilistic outcomes. In a portfolio of many stocks, your goal is to achieve profitability on the overall level. Trying to hit a home run with every stock is next to impossible, even for an investor like Warren Buffett.
Legendary investor Peter Lynch once claimed that with a success rate of 30-40 percent, an investor could end up with a very good performance record over a long term.
Moreover, it doesn’t matter how many times you’re proven right in your stock picks. What matters is how much money you made when you picked a good stock and how much money you lost when you invested in a bad stock. For a profession like Venture Capitalism, a success rate of 10-20 percent is considered very good because the size of their winners is so big that other 80-90 percent failure cases don’t matter at all.
In Safal Niveshak’s value investing workshops, Vishal often holds out his cell phone in his hand asks the participants to guess its weight. Most people try to estimate the phone’s absolute weight. To which, Vishal points out that the weight of the phone depends on how long he has to hold it. The longer he sticks out his hand clutching the phone, the heavier it feels.
The same is true with the bad stocks. The longer you hold, the more painful they are to hold.
Do yourself a favour, let go of those stocks.[/show_to] [hide_from accesslevel=’almanack’]
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