SERIOUS MONEY:THE FIRST QUARTER is well and truly over and investment managers are busy restructuring their portfolios to reflect their updated views of the world.
Unfortunately, far too much time is devoted to the identification of new “buy” ideas, when weeding out the portfolio’s deadwood would, in all likelihood, prove to be a more fruitful pursuit. Instead, most investors fund new positions through the sale of winning positions, and consistently violate the investment dictum, “Ride your winners, cut your losers”.
Research shows that investors view the sell decision as being three times more difficult to make than the buy decision, yet the typical investment manager spends seven times more time and energy seeking out new investments than they do on terminating stale old positions. As Philip Fisher observes in his classic, Common Stocks and Uncommon Profits: “More money has probably been lost by investors holding a stock they really did not want until they could ‘at least come out even’ than from any other single reason.”
To appreciate the psychological process of aversion to a certain loss, which occurs during risky decision-making and causes investors to hold on to losing positions for far too long, consider the following problems:
First, imagine that you face the following choice. You can accept €3,000 for certain, or you can gamble with an 80 per cent chance of winning €4,000 and a 20 per cent chance of winning nothing. Would you accept the guaranteed €3,000 or take the gamble?
Second, imagine you can pay €3,000 for certain, or you can gamble with an 80 per cent chance of losing €4,000 and a 20 per cent chance of losing nothing. Would you pay the guaranteed €3,000 or take the gamble?
Both problems have the same expected value except that the former is defined in the domain of profit and the latter in the domain of loss. The different choices made are striking in that most individuals take the certain gain offered in the first problem, and accept the gamble offered in the second problem.
Indeed, Nobel Prize winner Daniel Kahneman – working alongside the late Amos Tversky – found that 84 per cent of test subjects selected the guaranteed sum in the first problem, and 70 per cent chose to take the gamble in the second problem.
This bizarre behaviour stems from our neural circuitry, which has evolved to pursue rewards and avoid danger. Brain scans that track oxygenated blood flow show that the anticipation of monetary reward triggers the release of dopamine – the body’s pleasure chemical – and produces a biological effect that is equivalent to a high sparked by the ingestion of cocaine or love-making. Further, our innate desire for instant gratification motivates us to capture certain gains through the sale of winning positions far too soon.
Meanwhile, at the other end of the spectrum, actual or prospective financial loss activates the same part of the brain as physical pain, and the hurt caused by a $100 loss is roughly 2½ times greater than the pleasure derived from a $100 profit. Adrenaline is secreted into the bloodstream in response to the threat of financial loss, and the feelings of anxiety, fear and nervousness that arise can be so intense that they override the intentions of even the most deliberate thinking.
To avoid the pain arising from a prospective financial loss, most investors bury their heads in the sand like ostriches and pretend the loss doesn’t really exist. Needless to say, behaving like a 200-pound bird with a two-ounce brain inevitably proves self-defeating, as losing positions continue to grate on performance. Disturbingly, some investors compound the problem and add to the losing position in a desperate attempt to increase the chances of breaking even.
The human brain perceives the potential rewards and losses on Wall Street in the same manner that our ancestors struggled for survival on the Serengeti, yet most investors believe that the resulting emotional quirks, which cause the average investor to come up short in the financial markets, apply to others and not to them.
Unfortunately for them, investors’ tendency to sell winners too soon and hold losers too long is widely documented across the globe. One study shows that investment managers in Israel hold losing positions more than twice as long as winners.
Another study demonstrates that Finnish investors are 1½ more likely to sell a stock after a sharp rise than after a fall.
Finally, a comprehensive US study shows that among more than 400,000 trades in 8,000 accounts at a US discount brokerage, more than one-fifth of retail investors never sold a single stock that had dropped in price.
The dictum, “Ride your winners, cut your losers” ranks among the most important in the investment rulebook, precisely because human nature causes investors to do the exact opposite.
Bernard Baruch, the legendary investor known as the Lone Wolf of Wall Street, observed that “even being right three or four times out of 10 should yield a person a fortune if he has the sense to cut his losses quickly on the ventures where he has been wrong”.
Investors should take note.
