We sell our winners too early and ride the losers straight into the ground. This self-destructive pattern even has a name. It’s called the “disposition effect.”
Why do we do it? Ravi Dhar and Ning Zhu of the Yale School of Management believe that the disposition effect is real but that professional investors are less prone to it. One reason is because such investors are more able to confront bad news and admit error. But the madding crowd seems to lack this armor. Basically, we can’t handle the truth.
To deal with such messy, emotional, but real issues we convened a special, more intimate meeting of the Forbes.com Investor Team. On one side of the table we have Michael Ervolini, the head of Cabot Research, which applies behavioral finance to its mostly institutional client base. Behavioral finance applies the lens of psychology to the seemingly cold, rational world of business and investing. On the other side of the discussion we have Marc Lowlicht, the head of the wealth management division of Further Lane Asset Management. Lowlicht is on the front lines, dealing with unhappy, stressed customers who feel panicked and powerless as their portfolios shrink.
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What Ervolini has found is that many of our seemingly rational decisions–good or bad–are based on emotions hard-wired into us. Greed, embarrassment and shame are often in the driver’s seat, no matter how much we would like to think otherwise.
In the case of stock sales, here’s the problem: it’s been documented that the pain of losing money is twice greater than the joy of making it. So if you buy a stock and it goes up $2, you’re tempted to sell. Investors love to take small gains off the table. If it goes down $1, most investors will refuse to take the loss. They will hang onto the loser in the hopes of making that dollar back. That $1 loss has as strong an effect on the brain as a $2 gain.
“As long as the loss is hanging in the portfolio it has a chance of coming back,” Ervolini says. “But once you sell a position, that position is a loser forever and a little bit of you is a loser forever.”
Another problem Ervolini has found is that the same part of the brain that reacts with horror to death and disease is the one that’s affected by financial losses. This stretches far back in our evolutionary history. In less civilized times, a financial loss, or the loss of a source of gathered or hoarded food, could lead quickly to death. We react the same way to the nest egg that’s meant to see us through retirement.
There is very little research on the subject of stock sales. Ervolini found just one paper. But as shown by the recent market meltdown, selling is often the more critical skill.
Another issue Lowlicht confronts is that his customers often don’t understand that there can be no real growth without some risk. The problem, Ervolini counters, is that so few of us truly know how much loss we can bear. Often it is much less than we initially believe. “Know Thyself” might be a classic ideal but for many it remains just that.
Why We Can’t Sell
Forbes: Mike, one thing you’ve mentioned is the anti-selling bias. You can be a good buyer of securities or a good seller, but usually people aren’t both. Why is there this anti-selling bias?
Michael Ervolini: Well, I can relate it to [mutual fund] managers and then we can try to then relate it to individuals. From managers, there’s a technical and an emotional explanation. The technical one is that for the past 30 years virtually every dollar invested in studying the strategic part of investing has been about buying. It’s research for ranking stocks. It’s portfolio risk management. It’s optimizers. It’s tools that do attribution analysis and on and on. It’s all looking at what you own and what you’re going to buy today. We did some extensive work on this and we found one academic article on selling.
Forbes: One? Was it a good article?
Ervolini: It was pretty good.
Marc Lowlicht: Compared to the others, it was great.
Ervolini: And there are no real heavy books on the subject. Everybody’s oriented toward buying in terms of the profession. We talked to the people at Tower Research who do financial research. They agreed that 80% or more of the dollars that they see invested are on buying. In terms of research, capital, etc. So selling has just been under-served from the industry’s perspective.
Our academic adviser, Terrance Odean [the Willis H. Booth Professor of Banking and Finance at the Haas School of Business at the University of California, Berkeley] has expressed a behavioral approach this way: When you buy something–and we’re looking at long portfolios for a second–it’s out of hope. What can this position do for me? It’s a pretty nice place to be. When you sell, it’s because of what the position did to you. And maybe there’s just some natural inclination to want to spend more time thinking about buying because it’s just a more pleasant thought process as opposed to selling. But, I can tell you we’ve looked at just scores and scores and scores of funds and we see it over and over again.
And when we talk to professional managers, it resonates. “Yeah, I have some concerns about my selling and I’m glad to be able to have a really thorough examination of just my selling. Because I know I can make it better.” And it’s they don’t have in their organization feedback mechanisms to help them do it.
Lowlicht: Can I add something else in there that I’ve observed? Part of my business is to understand how people think because I have to guide them based on that. I think another reason people are better buyers than sellers is because when you buy, there’s no tally to how you did. If you lose, it’s a paper loss. “It’s still a good company. It’s going to come back.” But when you finally sell something, if it goes higher, you sold too soon. If it goes lower, you made the right decision. If you outperformed, you did great. So, people like to be winners. People like to be right. That’s why people argue. And when you buy, there is no weighing system as to whether you’re right or wrong until the sale is made. So, it’s much easier not to second guess a purchase.
And even if you bought Citigroup at $12, you can make a hundred excuses why you think it’s going to $20. You still made the right decision. And right now, it’s just a paper loss But once you make a sale, your decision has been final and there’s an accounting for the decision you made.
Ervolini: In behavioral finance, exactly what Marc’s talking about is known as the disposition effect. And what we see repeatedly is that people love to take small gains off the table. We see it repeatedly, retail and institutional. People love to take gains for two reasons. Ten $1 gains make us feel better than one $10 gain. That’s just the way our brains work. We like lots of small rewards as opposed to one big one. And once the gain starts to get up there, like $3-$4, we get fearful that the market will take it away. So, those two motivations cause us to take gains early.
And with losses it’s what Marc was saying. As long as the loss is hanging in the portfolio, it has a chance of coming back. And we can postpone the self recrimination. But once you sell a position, that position is a loser forever and a little bit of you is a loser forever.
The other thing to keep in mind is that studies have shown that the emotional high we get from a dollar of win is only half the emotional low we get from losing a dollar. So a loss is twice as impactful as a win in money. We hate to lose and it’s something primitive.
Forbes: Do investors really believe there is no reward without risk?
Ervolini: Oh, there’s always a trade-off. When you allay someone’s fears by changing their investment strategy, you’re giving up return. And there’s no way around that. The problem is the general investing public is misled into believing that return is magically created with no risk.
Lowlicht: And I think one of the problems is people want something for nothing almost. I don’t know if that’s the right terminology, but they have expectations of receiving, but don’t consider what they give up. And they want to believe that there’s a free lunch, that there’s an easier way to do it. Or that somebody else has figured it out. Nobody else has figured it out. You’ve got a certain amount of return for the amount of risk you take. The more risk you take, the greater the return. The less risk you take, the less the return.
Ervolini: This is tough because one of the things we’re not good at appreciating today is what a future outcome will feel like. And so, if Marc’s interviewing me and he says to me, “Mike, can you handle a 5% draw down on your account?” I say, “Yeah, sure.” And he says, “How about 10%?” I say, “Yeah, sure.” And then he keeps going on and on. And he finally gets to a number where I say ouch. Let’s say it’s 40%. So now, based on his interview, Marc has a sense of one dimension of my risk tolerance. And then what happens is we’re running down the road and my account gets drawn down 12% and I’m on the phone begging him to help me. Because I can’t really appreciate what a 10% or 15% draw down feels like until I get there.