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Why Most Investors Refuse to Sell a Losing Stock
We hate to lose and we hate to admit we’re wrong. We hate to lose in games, a simple bet such as a coin toss and especially, in the stock markets. It is hard to deal with loss, and it’s only human to feel that way.
No one likes to lose things they own, be it monetary or non-monetary. It’s always comforting to know that you have an abundance of money and possessions.
But in life, losing is inevitable. And TED speaker Laurie Santos thinks that the sooner we come to terms with that fact, the better our money decisions will be. Warren Buffett is wealthy not because he never loses money, it’s because he’s better at minimising his losses and capitalising on his wins.
Most investors refuse to sell a losing stock because of loss aversion, a term used very often in behavioural finance and economics. When we sell a losing stock, we lose money, and we really hate losing and being wrong.
It is more painful to lose than gain
TED speaker Laurie Santos is a cognitive psychologist and she shared a study she did years ago. Although the study was done with monkeys, she quickly proved that we were all quite similar when it came to losses.
She claimed that if we (and monkeys alike) are given $1,000 and two choices – safe or risky. The safe choice is to earn $500 for sure and the risky choice is to have a 50/50 chance of earning either $1,000 or nothing at all. According to Santos, we are more likely to take the safe choice.
In another case, we are given $2,000 instead and our safe and risky choices. The safe choice is to lose $500 for sure and the other risky choice is to have a 50/50 chance of losing either $1,000 or lose at all. In this different scenario but exactly the same outcome, we are more likely to take the risky choice.
We don’t have to be right all the time
Photo credits: DonkeyHotey on Flickr
This is not to say that we shouldn’t take risks at all. Investing in itself poses risks. It is not possible to be right all the time, especially when the stock markets are inherently psychological phenomena fuelled by human emotions.
But if we want any chance at getting rich from investing, it is not about being right all the time, but knowing when to cut losses when we’re wrong. The real question is, how?
Set a stop-loss
Nowadays, trading can be done online, although some investors still prefer to have a human to do it for them. But most investors don’t tend to set a stop-loss, that is setting a selling price when the stock price falls.
For example, you can set the stop-loss to be at eight percent. So when the stock falls eight percent below the price at which you purchased, it will be automatically sold to minimise losses.
This is a very simple principle and tool all investors and traders can use but seldom do. Setting a stop-loss is like preparing yourself for a loss. That’s loss aversion making you confused between “being prepared” and “being pessimistic”.
Apply it to winning stocks too
What most investors would do when stock prices plummet is to give the “I’m in for the long-term, so let’s just wait and see.” They say this even in face of the fact that the company might no longer be run by a good management team or the business might no longer be viable.
We can do the same for the winning stocks in our portfolio. Investors are investors and not traders because they are in for the long-term. But there are times where you need to let go of the stock if the company is no longer the same good company when you’ve first invested in it.
While stop-loss strategies don’t ensure that we make high returns from the stock market, being able to deal with our innate loss aversion will help us make more rational decisions. Investing is a long journey and it’s those with the self-discipline and willpower who would have higher chances of achieving their financial goals.
*Key points in this article were taken from a TED talk back in July 2010, by Laurie Santos.
