Ever taken profits on an investment at the slightest whiff of volatility only to see its share price soar higher a few days/weeks/months later? Don’t despair, most of us struggle to keep our fingers away from the ‘sell’ button, even when things seem to be going swimmingly. Here’s why.
Know your enemy
The tendency of investors to sell their winners (and retain their losers) is what behavioural finance boffins call the disposition effect. It happens because we’re primed to do what makes us feel good and avoid things that cause regret.
The disposition effect has its roots in the work of psychologists Kahneman and Tversky. They believed most people looked on losses and gains differently. When faced with two options, we’re more likely pick the one presented in terms of potential gains over the one presented in terms of possible losses.
Here’s an example. If I were to give you the choice of a) winning £20 or b) winning £40 and then losing £20, what would you do? Research shows that people would pick the option a), simply because we’re hardwired to avoid the greater emotional impact caused by option b). By choosing the latter, we’d inadvertently make £40 our reference point. To then walk away with anything less would feel like a loss, even though the actual choice doesn’t matter — you get a crisp £20 note whichever option you go for.
It works the same way in investing. We’re far more likely to realise a small gain rather than hold on for a potentially far larger one because the pain we’d feel if the latter were to then reduce would be too great. Besides, a profit is a profit. It feels good to be right.
To make matters worse, we cling to losing stocks. After all, in addition to hurting financially, it would involve us acknowledging we’d made a mistake at some point in our selection process.
The real kicker in all of this is that research has shown that the stocks sold by investors (the winners) tend to continue outperforming the losers they hang on to.
To be clear: over a long enough time period, the disposition effect could seriously reduce your chances of achieving financial independence. So, knowing that we have a habit of behaving like this, what can we do to reduce our susceptibility to it?
Start by ignoring your gains. Instead, focus on re-evaluating your winner. Was the company undervalued to begin with? While it now trades at fair value, that’s still no reason to sell if the story hasn’t changed. Even companies with seemingly inflated valuations can be worth sticking with if the future looks rosy. That’s why I remain invested — for now — in companies like Blue Prism and boohoo.com, despite both registering incredible share price gains over the last year.
Also consider the consequences of selling. Is it worth taking profit on a seemingly great company to reinvest in what might turn out to be a very average alternative? If it’s true that great investors hang out with great companies, why leave the party so soon?
Remember that successful investing is not about how many winners you own but how profitable they are. A few great stocks held for the long term can be far more rewarding than a portfolio full of average ones.
Learn from the...worst
If you're looking to maximise your chances of success in the stock market, it's often a good idea to learn from the errors of others.
That's why you really can't afford to miss a special report from the Motley Fool's analysts detailing the worst mistakes investors make.
Click here for your copy. It's completely FREE, without obligation and could save you a fortune.
Paul Summers owns shares in boohoo.com and Blue Prism. The Motley Fool UK has recommended boohoo.com. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.