What happens when you buy a stock
and it drops by 30 percent? Do you sell or do you hang on
hoping that it will come back to its original price? If
you usually hang on, then you may be suffering from get-evenitis,
a highly contagious disease particularly among males.
If you buy XYZ for $20 and it drops to $12,
you now own a $12 stock. It does not matter how it arrived
at this price. The question now becomes, "If I had
$12, would I buy a unit of XYZ or would I buy something
else?" If the answer is to buy XYZ, then hang on to
it. Otherwise sell it. Unfortunately our ego will goad us
into all sorts of rationalizations why we should not sell
at a loss.
We want to be able to say, "It's only
a paper loss. Don't worry. It will come back." Worse
than having our teeth pulled is being forced to utter "I
made a mistake." Even "There was a downturn in
the market which caused XYZ to go south" is hard for
most of us to say. Just as in real life, sometimes we have
to face our mistakes and accept a loss before we can move
In 1995 Nicholas Leeson became famous for
causing the collapse of Barings Bank, his employer. Over
the previous years he had some serious losses. Instead of
admitting them, in his own words, he "gambled on the
stock market to reverse his mistakes and save the bank."
But things just got worse and he ended up losing $1.4 billion.
It is unlikely that any of us are going to
catch such an acute case of get-evenitis. More likely it
will be a low-grade infection that eats away at our investing
Get-evenitis has an associated disease called
consolidatus profitus. Where you see one, you usually see
the other. Sufferers of consolidatus profitus are often
heard intoning "You can't lose money by taking a profit."
You may not lose money for that particular
stock, but in the end what makes the difference is what
we do with our profits. What if we put the money from the
sale into a stock that is a major underperformer? We may
be able to say that we made a profit on a particular stock.
What we are not saying is that our portfolio went down because
of the way we spent the profits.
If ABC goes from $20 to $30, then you now
own a $30 stock. In the same way that you examined the loser
above, think what you would do with $30. If you would buy
ABC for $30, then keep the stock. If not, then sell it.
Of course, in real life things are a bit more
complicated since we have to take into account transaction
costs and taxes. But I think the general idea is clear-evaluate
your stocks on what return you expect to get from them in
the future, not on what they have done in the past.
Just how wide-spread are these diseases follows
from a large-scale study carried out by Terrance Odean of
the University of California in Davis. Reporting in the
Journal of Finance, 1998, he found that people tended to
trade out of winners into stocks that performed less well.
Overall he found that people would have been better to sell
their losers and keep their winners. Instead, they did the
opposite, namely keep their losers and sell their winners.
To get a rough idea of the size of the losses,
imagine an investor that has two stocks to sell, one a past
winner and the other a past loser. Using data from Odean's
study, the average return on the past winner over the next
year was 2.4 percent above the market average compared to
a 1 percent loss on the past loser.
This means that holding on to your winner
would put you 2.4 percent ahead of the market during the
next year. In contrast, holding on to the loser would put
you 1 percent behind the market. But this is just what the
average investor did. On average, investors choose to sell
their winners more often than their losers.
The difference between the two strategies
is even more marked when taxes are taken into account. When
you claim a loss you are getting a tax rebate and so you
want this as early as possible. In contrast, with a profit
you are paying tax so you want to delay this as long as
possible. But, as we just learned, the average investor
tends to take profits early and losses late ending up on
the wrong side of the taxman.
Actually, some investors are aware of these
tax consequences. The above findings are actually for the
months of January to November. In December, there was a
slight tendency in the opposite direction with losers being
sold more often than winners.
There are two primary explanations as to why
investors sell winners more often than losers. The first
explanation is what was described above, the aversion to
having to admit that you made a loss is greater than the
joy of being able to announce a success.
The second explanation is that investors generally
believe in mean reversion for stock prices. This is the
concept that over the longer term, stocks that go down will
move back up to their original price whereas stocks that
go up will come back down to their original price. Alas,
if only the stock market was so simple. The results of Odean's
study indicate that the opposite is more likely to happen,
stocks that have gone up will go up even more, and stocks
that have gone down will go down even more.
Of course, none of the above would come as
a surprise to people familiar with the world of trading
where the maxim "cut your losses short and let your
profits run" is a basic tenet. In his famous book How
to Make Money in Stocks, William O'Neil wrote, "If
you want to make money in the stock market, you need a specific
defensive plan for cutting your losses quickly and you need
to develop the decisiveness and discipline to make these
tough, hard-headed decisions without wavering."
The moral is to take a hard look at the stocks
in your portfolio using objective criteria such as contained
in Conscious Investor. Make your buy/hold/sell decisions
on a careful appraisal of the profit you expect from them
in the future and not on emotional attachment or pride.
If you do this you will have inoculated yourself against
the maladies of get-evenitis and consolidatus profitus.