Many investors have compounded their losses by holding a share until they could ‘at least come out even’. They may not like the company as an investment anymore but they are loath to give up and admit defeat and crystalize a loss.
Not only is there a danger that the share will keep going down but there is often a large opportunity cost as the investor forgoes profits that might have been made through the reinvestment of the money that could be realised.
To hold on so that you do not have to tell anyone (including yourself) that you made a mistake and have made a loss is mere self-indulgence. Accept your mistake and move on.
Academics have produced reams of evidence showing that shareholders have a tendency to sell their winners too early and to stick with their losers too long.
This area of literature is referred to as the “disposition effect” which is short hand for “pre-disposition to get-evenitis” (Shefrin and Statman 1985)
Terrance Odean (1998) looked at 10,000 investor accounts at a brokerage and found that over an average year investors sell a higher proportion of their winners (15%) than their losers (10%). They held winning positions for 104 days, but held losing positions for 124 days.
This would be fine if the investment returns justified the behaviour. But when Odean observed the subsequent performance of the winning shares that had been sold, he found that they went on to out-perform the losing shares which had been held. He wrote:
“For winners that are sold, the average excess return over the following year is 3.4% more than it is for losers that are not sold. Investors who sell winners and hold losers because they expect the losers to outperform the winners in the future are, on average, mistaken.” (Odean 1998, Why are investors reluctant to realize their losses?)
What is the impact of this human tendency?
Odean had the following to say:
“Let us imagine that a hypothetical investor is choosing to sell one of two stocks. The first of these stocks behaves like the average realized winner in this data set and the other like the average paper loser. The investor wishes to sell $1,000 worth of stock after commissions and that happens to be what his position in each stock is currently worth. Suppose he is averse to realizing losses and so sells the winning stock. If his experience is similar to that of the average investor in this data set, his return on the sale will be 27.7%. Since the stock is currently worth $1000, its purchase price must have been $783, and his capital gain is $217. If he instead chooses to sell $1,000 worth of the losing stock, his return will be -39.3%, with a purchase price of $1,647, and a capital loss of $647. One year later the stock that he held will have, on average, a return 1% below the market; the winning stock that he sold will have, on average, a return 2.4% above the market.” (Odean 1998)
It helps if you have been investing for a while
It would seem that more sophisticated and experienced investors can dampen the disposition effect (e.g. Dhar & Zhu 2006, Da Costa et al 2013).
For example, Lei Feng and Mark Seasholes (2005) reckon “Sophisticated investors are 67% less prone to the disposition effect than the average investor………Trading experience on its own attenuates up to 72% of the disposition effect, but does not totally eliminate the behaviour…….. A combination of sophistication and trading experience eliminates the reluctance of in.....To read more subscribe to my premium newsletter Deep Value Shares – click here http://newsletters.advfn.com/deepvalueshares/subscribe-1
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