"You got to know when to hold ‘em, know when to fold ‘em, know when to walk away and know when to run.” (From The Gambler, performed by Kenny Rogers, written by Don Schlitz.)
Date: Mar 22, 2012 Author: Peter Brooks
Keywords: Behavioural finance, Bias, Risk, Disposition effect
"You got to know when to hold ‘em, know when to fold ‘em, know when to walk away and know when to run.” (From The Gambler, performed by Kenny Rogers, written by Don Schlitz.)
When Kenny Rogers sang about the difficulties of being a good poker player, he probably did not realise that he was also describing many of the difficult decisions that investors face on a daily basis.
As investors, we are always making decisions about what to hold and what to remove from our portfolios. One of the almost universal psychological tendencies is that we focus on past performance in these decisions more than we should. Past performance is the only thing we know with any degree of certainty so we naturally use it as a crutch in our decisions even though our decisions can only affect future performance.
Imagine you are very interested in taking on a new position, but you have to sell an existing position to fund it. Individual investors have a psychological bias towards selling investments which have gained in value rather than the ones that have lost value. This is called the “disposition effect”.
One estimate suggests that you would be 50% more likely to sell an asset in the black than a one in the red to fund your new investment.
When we buy a stock we mentally open an artificial “account” that allows us to track performance relative to our purchase price. When we sell that stock we "close" the mental account at either a gain or a loss. While this feels intuitive to many of us and our clients, it can leave us open to other damaging biases, including the disposition effect.
For example, if you are holding a losing stock you have two options: close your position and be certain about the amount of your losses; or risk losing more to retain the chance of getting back to par.
Investors tend to hold risky positions in the hope of recovering their losses. This is a widely observed tendency in risk-taking – we are risk-seeking when faced with the prospect of losses, but risk averse when we have the opportunity to take gains. Our risk aversion for gains means we prefer to sell positions and be certain about locking in the gain rather than risk losing those gains for the chance to get more.
This can lead us to sell our winners and hold our losers.
Additionally, we tend to like to avoid negative feelings. Selling a losing investment and crystallising a loss makes us feel much worse than holding a paper loss. Only when we sell is the loss truly realised and we have to admit that we made a bad investment. While we hold the investment there is always some chance that it will increase in value back to where we bought it. Selling assets that have gained in value, by contrast, makes us feel like smarter, better investors and proud of our investing prowess.
This desire for pride, and avoidance of regret, also reinforces our disposition to sell winners and hold losers.
Ultimately, the disposition effect reduces portfolio returns because it takes the momentum out of a portfolio. Holding losers becomes a drag on performance.
The rational approach is to respect your risk tolerance and position yourself in those investments that you think will give the best return in the future – the past is relevant only insofar as it provides information about the future prospects of an investment. At times you need to take the emotional hit of accepting a loss on your investment in order to position yourself for future gains.
Clearly this is easier said than done. I would suggest three simple things for advisers to get clients to think about.
First, ask your client to focus on future expectations for their investments and not the past. Although this is difficult, because the past is the only thing we know with certainty, it is good investing behaviour. To help keep a sense of perspective it is often useful to ask: “If you did not own that investment, would you buy it now?” If the answer to that question is “no”, then you should be looking for better places to invest that wealth.
Secondly, you should look for ways to keep the artificial mental account “open”. One way to do this is to encourage your clients to think about switching between investments and rolling their position to a new investment. This simple reframing of the problem avoids the pain and regret of closing out an account at a loss.
Finally, holding any investment carries a cost of not taking the opportunity to hold a different investment. This is true for winners as well as losers – if you hold a winner which you think has momentum left in it, restrain yourself from cashing in the gain and ride it for a bit longer.
All of this may appear inconsistent with my typical advice that rebalancing your portfolio to an asset allocation is good investor behaviour. After all, rebalancing forces you to sell winners and buy losers.
However, if you implement your portfolio through individual stocks rather than diversified funds, your rebalancing is actually the perfect opportunity for the disposition effect to damage your portfolio. If you allow the disposition effect to affect your selection of which stocks to sell you may be taking the momentum out of your portfolio and thereby reducing your future returns.
The disposition effect can be damaging to your portfolio, whether you are an active trader or someone that prefers to follow an asset allocation, but recognising its effects and making simple modifications to how you think about investing can reap rewards. As Kenny Rogers put it: “You got to know when to hold ‘em, know when to fold ‘em.”
[1] Shefrin, Hersh and Meir Statman, The Disposition to Sell Winners Too Early and Ride Losers Too Long: Theory and Evidence, The Journal of Finance, Vol. 40, July 1985
[2] Barber, Brad M. and Terrence Odean, The Courage of Misguided Convictions, Financial Analysts Journal, Nov/Dec 1999.
