Loss Aversion in the Stock Market: Watering the Weeds and Cutting the Flowers

 

Investors often hold losing stocks for extended periods of time and sell winning stocks too early (1). At best, this reduces gains. At worst, this results in large losses.

Loss aversion is a psychological bias that can result in irrational behavior (2,3). For many people, the pain of loss is much more intense than the pleasure of gains. In fact, it takes approximately twice as much of a gain to offset the pain of a loss. For example, many people would say they are indifferent between losing ten dollars and gaining twenty dollars. If people were rational, losing ten dollars would be perfectly offset by gaining ten dollars.

In the stock market, people often hold declining stocks to avoid realizing loses. These people find the unrealized paper loss more palatable than a realized loss. These individuals hope the stock will rebound so they can avoid the pain of a loss. If the stock price decline is due to poor current and projected earnings, holding the stock simply to avoid the emotional pain of loss is a recipe for financial under-performance. This is “watering the weeds”.

Similarly, people may sell stocks earlier than necessary to lock in gains. Selling when the stock is up locks in the gain, resulting in emotional gratification. Selling when the stock is up also avoids the pain of loss if the stock later declines. In some cases, the stock could be gaining because of excellent current and projected earnings. Selling the stock of a great company out of fear of losing gains is also a recipe for financial under-performance. This is “cutting the flowers.”

One way to overcome loss aversion is with a mindset shift: instead of seeing a declining or increasing stock as a threat, view it as a signal to reevaluate the investment’s fundamentals (1,4,5). Some questions to address include: Do financial statements still show acceptable earnings and equity over the long-run? Is the company generating and using cash wisely? Does management have a coherent business strategy? Does the business have a sustainable competitive advantage?

Conclusion: If fundamentals are poor and/or declining, it may be time to sell. If fundamentals are acceptable and/or improving, the investment might be good to hold. The key is to ask yourself if loss aversion is at play to make rational investment decisions. Remember, Graham’s Mr. Market obligingly provides stock prices at a rapid pace. It is up to you to decide how close the price is to the actual value of the business (6).

References:

1. Shefrin H & Statman M. The disposition to sell winners too early and ride losers too long: Theory and evidence. The Journal of Finance, 1985; 40:777–790.

2. Kahneman D & Tversky A. Prospect theory: An analysis of decision under risk. Econometrica, 1979; 47:263–291.

3. Thaler R. Mental accounting matters. Journal of Behavioral Decision Making, 1999; 12:183–206.

4. Buffett W. Berkshire Hathaway 1988 shareholder letter. Berkshire Hathaway Inc.

5. Lynch P & Rothchild J. One Up on Wall Street: How to Use What You Already Know to Make Money in the Market. Simon & Schuster, 1989.

6. Graham B. The Intelligent Investor: The Definitive Book on Value Investing. Revised edition, updated with new commentary by Jason Zweig. Harper Business, 2006.

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