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Holding onto a losing share for too long

23 May 2014

The saying goes that ‘a fool and his money are soon parted’. A corollary might be that a fool and a losing share are not parted soon enough. This article briefly examines that proposition.

In the last fifty years or so, highly respected academics have used experiments and real market studies to demonstrate beyond doubt that almost all investors rely more upon emotional triggers than calm reason when it comes to the buying and selling of stocks.

One unusual manifestation of this finding is that, when faced with funding a sizeable expense (e.g. education fees, an overseas trip) investors almost always sell well-performing stocks while holding on to underperformers. This counter-intuitive action frequently sees the stocks that were sold continue to rise (or at least strongly rebound), while retained stocks remain relatively static or, worse, fall even lower.

What makes private investors (and too many fund managers) act in this way?

The answers are provided by pioneers of what has become known as ‘behavioural finance’.

Although their names are rarely well-known to the investing public, such luminaries as Daniel Kahneman (winner of the Nobel Prize for economics), Amos Tversky, Richard Thaler and James Montier have published papers and written books to demonstrate the efficacy of theories and practical findings relating to how investor behaviour generally relies more upon emotion than reason in making investment decisions.

There are several components to such behaviour, and because investors are human, most are familiar with their effects.

‘Mental accounting’ is one contributing factor. This phenomenon sees the price paid for a share as an ‘anchor price’; this price is a reference point around which most investors judge the performance of their share. Prices above the anchor price bring pleasure.

However, when the share falls below the price paid, investors experience another investment phenomenon known as ‘avoidance of regret’ because, in keeping with human nature, they are loss averse.

“The opportune time to sell a share is when its market price reflects the fundamental value of the business and has nothing to do with an investor’s emotional reference point.”

Here’s a highly relevant quote from LeRoy Gross (who authored a manual for stockbrokers), is poignant: ‘Many clients will not sell anything at a loss. They don’t want to give up the hope of making money on a particular investment, or perhaps they want to get even before they get out. The ‘getevenitis’ disease has probably wrought more destruction on investment portfolios than anything else. Rather than recovering an original entry price, many investments plunge sickeningly to even deeper losses.’

The truth is that a vast number of experiments have proven that people find losses more than twice as painful as they find gains to be pleasurable.

Are there solutions available to counter the proven tendency to ‘sell winners and ride losers’, also known as the ‘disposition effect’?

The answer is ‘yes’ but it requires a disciplined and intellectual framework of thinking. An investor’s focus should always be on the fundamental value of a business compared to its current price instead of a comparison of the current price and the price paid for it (the anchor price). This is a hugely important distinction in critical thinking.

In short, the opportune time to sell a share is when its market price reflects the fundamental value of the relevant business and has nothing to do with the investor’s cost basis (his/her/their emotional reference point).

At Joseph Palmer & Sons we learned long ago to remove emotion from the investment equation. The decisions we make on behalf of clients are based upon a rigorous system developed over many years: we call it ‘relative value analysis’ (RVA).

As its name suggests, RVA compares the real value of one security against another; this objective and rational evaluation determines whether we buy, sell or hold that security for our clients.

If it’s found that a security within a client portfolio continues to underperform, we transfer its value to others that, with analysis, can demonstrate upside opportunities. And the results are inevitably superior to hanging on to a share for too long. The way it should be.

Disclaimer & General Advice Warning

This publication has been prepared by Joseph Palmer & Sons (ABN 29 548 490 818) an Australian Financial Services Licensee (AFSL 247067). Whilst the information contained in this publication has been prepared with all reasonable care from sources, which Joseph Palmer & Sons believes are reliable, no responsibility or liability is accepted by Joseph Palmer & Sons for any errors or omissions or misstatements however caused. Any opinions, forecasts or recommendations reflects the judgment and assumptions of Joseph Palmer & Sons as at the date of publication and may change without notice. Joseph Palmer & Sons, their officers, agents and employees exclude all liability whatsoever, in negligence or otherwise, for any loss or damage relating to this document to the full extent permitted by law. This publication is not and should not be construed as an offer to sell or the solicitation of an offer to purchase or subscribe for any investment. Any securities recommendation contained in this publication is unsolicited general information only. Joseph Palmer & Sons are not aware that any recipient intends to rely on this publication and are not aware of the manner in which a recipient intends to use it. In preparing our information, it is not possible to take into consideration the investment objectives, financial situation or particular needs of any individual recipient. Investors must obtain individual financial advice from their investment advisor to determine whether recommendations contained in this publication are appropriate to their personal investment objectives, financial situation or particular needs before acting on any such recommendations.

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