It would be safe to say that loss aversion is ingrained in our in our genetic code. No one likes to take a loss and this often leads us to hold on to poor investments and bad companies. Rather than just cutting our losses we frequently delude ourselves by making up reasons why we think our investment will bounce back, even though we know deep inside that it probably wont.
To illustrate how loss aversion affects our behavior lets consider a coin flipping game for a moment. In this game we will be flipping a quarter and bet on heads or tails. If you lose you have to pay $100. How much would you need to win to want to play the game?
According to several different surveys the average person requires around $250-300 to play this game. That is essentially illustrates that the average person hates losing 2.5 to 3 times as much as they like winning, and shows loss aversion bias. If you are willing to accept $100 you are neutral and anything above $100 is an advantageous bet.
Because of our loss aversion bias we have a tendency of holding on to losing stocks. Many of us believe that a loss is not realized until you sell, and that may be true but it is not a good reason to hold on to a company that is deteriorating.
Holding on to a declining good stock where the facts suggest that it is undervalued and has become more undervalued is one thing but many investors simply hold on to stocks to avoid a loss in hopes that it will one day bounce back. This type of behavior is bad for two reasons. First, you are just sinking further and further the longer you hold the stock. Second you are holding on to capital that could be used for something better. Psychologically we feel that we need make up our losses on the stock that is losing value but this is far from the truth. Making your money back on another investment is just as good.
Studies show that we are more likely to sell winning stocks than losing stocks. But contrary to many believes the investors that take more losses tend to show better long term results. Andrea Frazzini of AQR Capital Management researched the subject and looked at the performance of thousands of fund managers. He discovered that the funds that had the highest ratios of realized losses compared to realized winners showed the best long term performance. The worst performing funds had the lowest percent of realized losses.
Selling at a loss is emotionally difficult. Therefore pre-committing to a plan and setting up an automatic stop loss beforehand will remove all emotions from the decision making process. A stop loss will prevent us from sliding down a slippery slope and holding on to a stock just because we dont want to realize a loss. Setting up a stop loss a strategy is a decision we can make when they are in a cold and rationale state of mind.
Deciding whether to sell a poorly performing investment can be a difficult decision to make as shown above. To help ourselves overcome our emotional attachment this exercise may be of help. Consider for a moment that you have been holding on to a stock that has been steadily declining in price, for whatever reason, for over a year and it is now worth 30% less than what you bought it for.
I imagine you are in the kitchen making some coffee while your little 3 year old nephew is playing on the computer pressing random keys. Your trading account is open and your little nephew accidentally presses a series of keys on the keyboard that sells out all your positions of this stock.
What will you do next? At this moment you can either repurchase the shares or you can simply realize the loss. When asked this question almost no one wanted to buy back the shares.
This phenomenon is known as the endowment effect and it says that we tend to place higher value on things we own that other people would. Richard Thaler who first hypothesized the endowment effect demonstrated it by a simple exercise in a classroom.
In a university classroom with 30 students, half of the students were randomly given mugs with a college logo. Then the students were told to form a market in which students with mugs could sell their mugs to students without mugs. Since half of the mugs were randomly distributed among the students presumably half of the people should want to trade. Thus the volume should be 50%. However, the volume was closer to 10% and there was a huge gap (spread) between the buy and sell price.
The mugs in the example were sold for $7 in the university store and those who held them in the class room were willing to give them up for $6 on average. However, those without mugs were not willing to pay more than $3 to buy one. So despite that students had only had possession of the mugs for a couple of minutes still led them to ask for double the price of what the buyers were willing to pay. This goes on to show how ownership tends to distort our perception of value.