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Let me start today’s post by asking you a question.
Assume that India is preparing for the outbreak of an unusual Asian virus, which is expected to kill 600 people. Two alternative programs to combat the disease have been proposed:
- If program A is adopted, 200 people will be saved.
- If program B is adopted, there is a one-third probability that 600 people will be saved and a two-thirds probability that no people will be saved.
Which of the two programs would you favor?
Well, if you think like 72% among a few hundred smart physicians who were asked a similar question by the Nobel Prize-winning psychologist Daniel Kahneman, you will choose option A, the safe-and-sure strategy.
Most doctors would rather save a certain number of people for sure than risk the possibility that everyone might die.
Now consider this second question…
India is preparing for the outbreak of an unusual Asian disease, which is expected to kill 600 people. Two alternative programs to combat the disease have been proposed:
- If program C is adopted, 400 people will die.
- If program D is adopted, there is a one-third probability that nobody will die and a two-thirds probability that 600 people will die.
Which of the two programs would you favor?
Do you see the dilemma here?
Saving one-third of the population is the same as losing two-thirds.
Yet, doctors reacted very differently depending on how the question was framed. When the possible outcomes were stated in terms of deaths (and not survivors), physicians were suddenly eager to take chances: 78% chose option D.
“Are such smart people like doctors so inconsistent?” you might wonder.
Well, Kahneman and his longtime collaborator, Amos Tversky, explain these contradictory responses in terms of “loss aversion”.
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In other words, they suggest that the reasons the doctors were so inconsistent was that, for us humans, losses hurt more than gains feel good.
So we are more unhappy seeing our stock fall 30% than we are happy seeing it rise 30%.
I suffered from this mental disease for long, but with regular observation of my emotions and some efforts to overcome them, I can say that I’ve got over it. (At least this is that I will continue to believe till I face my next bad stock!)
Imagine if I continue to practice ‘loss aversion’ by selling off my winners and holding on to my losers. I will end up exactly as most junk collectors do – with a portfolio of rubbish.
Over the long term, this strategy is exceedingly foolish, since it ultimately leads to a portfolio composed entirely of shares that are losing money.
But the fact remains that people hate losses so much that merely framing a choice in terms of a potential loss can shift their preferences.
Like those physicians, people are suddenly willing to risk losing everything (from falling stocks that might never come up) if there’s a chance they might lose nothing (“I think this stock will rise again!”).
Since Kahneman and Tversky began studying loss aversion in the early 1970s, it has been used to explain a stunning variety of irrational behaviors, from the misguided decisions of investors to the stickiness of housing prices in the aftermath of a housing bubble (builders and owners are not ready so sell their houses at ‘loss’ even if there’s little hope that the prices will rise again).
“Loss aversion” is also used to justify our fondness for the status quo.
“The present may stink, but I still don’t want to lose it,” we would comfort ourselves during adverse times.
What makes us averse to losses?
One reason is regret.
We often regret a bad outcome, such as a stock that has fallen after we bought it. This is despite the fact that we know we chose the investment for all the right reasons.
In this case, what regret can lead you to do is to make a poor ‘sell’ decision. You may end up selling a good company at a market bottom instead of buying more of it.
Alternatively, if it’s a bad company and you realize it after you buy it, you regret being proved wrong in your original judgment.
So to avoid being called ‘foolish’ by your friends and colleagues, you hold on and continue to silently suffer the loss.
Another factor that makes you averse to losses is the ‘sunk cost fallacy‘, which we had discussed a few months back on Safal Niveshak.
Here is what this fallacy leads you to think…
It’s now too late! I’m already down 50%. Now I don’t want to convert the paper loss into real loss by selling the stock. And then, I spent so much time and energy finding this stock. Let me wait for some more time for it to come back to my cost price and then I’ll surely sell.
So you end up with a situation where just because you have put a lot of time and energy into the selection of the stock, even when you realise that you must sell it, you are afraid to cut it loose.
How to get over ‘loss aversion’?
In Why Smart People Make Big Money Mistakes and How to Correct Them, the authors write:
Once your money is spent, it’s gone. It has no relevance. To the extent you can incorporate that notion into your financial decisions, you’ll be that much better off for trying. If you’re debating the sale of an investment (or a home), for example, remember that your goal is to maximize your wealth and your enjoyment. The goal is not to justify your decision to buy the investment at whatever price you originally paid for it. Who cares?
What counts, in terms of getting where you want to be tomorrow, is what that investment is worth today.
The crux of this is that you must learn to walk away from bad investing decisions you made in the past.
Just get over that ‘I can’t quit’ trap.
Your sunk cost is already sunk in the past. Now, don’t sink your future worrying about it.
So, while making the decision to sell a stock, forget about what you paid for it. This is because what you paid for a stock has no bearing on the future price.
Only consider what the intrinsic value is today.
Ask yourself, “If I didn’t have these shares, would these be worth buying now, at today’s price?”
If not, then sell it now.
Don’t let your ego ruin your investment returns. You’ve already had it enough!
Very interesting, at the same time its confusing a little bit, the decision to sell or hold is very difficult, the decision to buy is usually easy. I said a little confusing is because you said “Ask yourself, “If I didn’t have these shares, would these be worth buying now, at today’s price?” what if the price a paid of the stock jumped up drastically lets say 30 % in last two months and i am not ready to buy this stock at the same price, then should i sell it and book profits?, or are you only referring to the bad investment in this statement?
Thanks Vikrant! The decision to hold/sell a stock is as difficult as buying it (yes, even buying a stock is a difficult decision :-)).
As for your point about the stock jumping 30%, and if you are attracted by the rising prices (like most investors are), you need to ask the same question – “If I didn’t have these shares, would these be worth buying now, at today’s price?” If you believe 30% gain is all the stock can provide you even in the long term, and that the company’s potential does not justify a higher price, it’s better to sell the stock.
But in this post, I was largely referring to stocks that have fallen and then you hold on to it (because you hate losses) even after realizing that buying it was a mistake. In that case, it’s better to sell the stock instead of worrying about the price you paid for it. What matters then is to accept your mistake and reinvest the money in a better stock.
I hope that removes your confusion.
🙂
Let me first say yes it much clearer. thanks. and its easier for me cause we are still not doing the research like you do, so we use the Stock talk :). haven’t used it yet cause no cask,but will definitely use when the time comes. And until we learn how to select the stock.
I read Subras blog and your replies, was quite interesting are you friends?
Thanks Vikrant! Well, Subra doesn’t know who I am, so we are not friends (except on Facebook) 🙂
Hi,
The title seemed a bit confusing at first, but then I understood the explanation regarding loss aversion.
However, I would like to point out that there is a subtle difference between loss aversion and sunk cost fallacy. An example of Loss Aversion is the situation where an investor delays selling a losing stock simply because he/she doesn’t want to see the notional or paper losses become real upon liquidating the bad stock.
An example of the Sunk Cost Fallacy is when an investor tries to average his/her purchase price on a losing stock even when there is sufficient information that the original premise behind purchasing is no longer valid.
So, while an investor suffering from Loss Aversion stands to lose his original investment due to delayed decision, the investor suffering from Sunk Cost Fallacy falls deeper into the trap and throws new good money after bad!
Yes you are right, Ramanand! But then, you fall into the sunk cost trap only when you are averse to losses. 🙂
Nice article. very Interesting. Just love the way you express things.
Every trader or investor should read it once. it will prove to be of great benefit for them.
Thanks for your feedback, Stock Tips!
Excellent article. Although, loss aversion could be avoided by not selling the stock in panic provided they are fundamentally good picks. If we understand that we have committed the mistake of selecting wrong stock in the first place, it is ok to cut some loss and get out of it before it’s too late.
Like the first commenter wrote, these lines are a little confusing…
Ask yourself, “If I didn’t have these shares, would these be worth buying now, at today’s price?”
If not, then sell it now.
We know the story of Mr.Market and how it behaves. As long as we do a value investing, there should be no need to sell it.
Dear Vishal,
Let me acknowledge that I have quite a few mid and small cap stocks (even some largecap stocks) that are in deep losses in my portfolio. Let me also accept the fact that I am unable to decide on booking losses (I am experiencing exactly as written in sunken fallacy post) because some of the losses are very deep. I had taken help of paid research to pick my stocks and trusted that it makes sense to approach an ethical and honest paid service for stock research (not a broker). Fantastic opinions about management, valuation and other info were provided to me on each of those stocks. While I do not doubt their ethics, but the net result on my folio is I am in deep loss. Honestly, till I came in to safal niveshak, I did very negligible research on my own . Even now I have to accept the fact that I am still at K.G in stock analysis. I know have a long way to go before I become competent to analyse a stock by myself. Your initiative is certainly making me move in that direction.
Coming back to this article, after reading several safal niveshal articles, one thing is very clear to me is that one should buy or sell stock based on its intrinsic value. Now this article talks about selling a loss making stock by running a scan of : If I am not ready to buy at the current market price which is already fallen lets say 30 or 50% or even more, it is time to sell and invest that capital in other stocks to cover the losses.
But markets are not so rational. It can beat down a quality stock to unrealistic level and provide unwarranted valuation to a non worthy stock. So selling based on losses or decision of selling it out, if you are not ready to buy more does not make sense.
In fact all of my deep losses are due to the fact that I trusted the reports provided to me and the forecasts on each of those stock and their basis of valuation (in my opinion my paid research are value investors) and every time the stock went down, based on the reports and positive opinions given to me , I felt I am getting a better opportunity to invest in and went on averaging it out. In many cases, the paid research also advised me to average it out (although now they are sending notes to sell at loss).
Is there really a way out for a small investor who are not like you to analyze carefully the stock and decide upon which one to buy and which one to skip and at what price? Yes , your point may be that it is not difficult and one can easily do that. But, in reality it is a skill it takes long time to get there (even you would have taken quite some time to get there). But till that time what is the way out to invest and what is the solution to cover up exisitng losses. Is there any way to get a unbiased opinion on existing folio to decide on which stock to hold which one to sell and where to re-invest.
As a small time investor, it is very difficult to take that decision? Is there a way out? Can you help me please.
At some point of time, I felt to just quit the direct investing and simply invest in funds where I am much more comfortable and have plesant experience. Could you provide your feedback.
Regards
dear ajay,
u should invest in index etf’s and index mutual funds.