Have you ever struggled to determine when you should sell a stock? If you have, then you are not alone. Most investors focus almost all of their research on identifying stocks that they are interested in buying. Once they make an investment, however, many of these investors do not apply the same level of due diligence when selling their stocks. According to a recent survey, only 17 percent of individual investors felt that buying a stock is harder than selling. 62 percent of them spent more time researching their buying decisions than their selling decisions. Why do so many investors feel that selling stock is so much more challenging than buying stock? By combining psychology and economics, behavioral finance offers valuable insight into this phenomenon.
Selling Winning Stocks Too Early
Loss aversion is a well documented behavioral bias that stems from the fact that people feel more pain from a loss of a given amount than the joy that they feel from an equivalent gain. In fact, research indicates that the emotional pain associated with a loss is about twice as powerful as a gain of equal magnitude.
Although risk aversion can have important survival value in an evolutionary context, it can be very hazardous in an investment context. A good example of loss aversion is the tendency of investors to sell winning stocks too early. Once a stock has appreciated, human nature compels you to “lock in” your gain. If you do not sell the stock, one of two things could happen: the stock could continue to appreciate or the stock could reverse course and turn your gain into a loss. Accordingly, the mind’s desire to avoid the possibility of a future loss leads many people to sell winning stocks too early in order to avoid the possibility of a loss, which thereby limits the future gains that winning stocks often produce.
Holding Losing Stocks Too Long
Of course, loss aversion also manifests itself in the way investors handle declining stocks because many investors hold losing stocks far too long, with the hope that losing stocks will eventually turn into winners. Since the mind has a tendency to not acknowledge unrealized losses as “real” losses, investors often delude themselves into believing that declines in stock prices are not “real” losses until their stocks are actually sold. In addition to losing an opportunity to trim losses, one of the other problems with holding declining stocks is that investors lose the opportunity to offset taxable gains and reduce taxable income.
Even the best investors make mistakes. By acknowledging your mistakes and selling a losing stock earlier, you have the opportunity to learn from your mistake, replace a losing stock with a winning stock, and reduce your tax liability. An unrealized loss does not represent any economic value to you, but a realized loss will save you money on taxes and provide capital for new investments.
Your Purchase Price Should Not Affect the Sale Price
One of the primary reasons that losing stocks are held too long is the fear that a losing stock will rebound after it is sold and allow you to “break even.” All dollars, however, are created equal; and you do not have to recoup losses with the same stock that generated those losses. Often you may be better off replacing the declining stock with one that has better prospects. After all, there is often a good reason that a stock has declined.
Far too many investors base their sell decisions on a stock’s past performance, when their focus should be on a company’s future prospects. In fact, your purchase price should not influence the price at which you sell a stock. It is important to remember that stocks represent businesses. If a stock is trading for more than you think the business is worth, you should sell it; and if a stock is trading for less than your fair value estimate, then you should hold it. Your purchase price should not be a factor in your decision to sell a stock.1
A disciplined approach to selling stocks is one of the key differences between professional investment managers and individual investors. In order to combat the detrimental effects of loss aversion, you should try to focus on the tax benefits that result from timely replacement of declining stocks. And always remember that what you paid for a stock should have no bearing on when you sell that stock.
If you need help counteracting the irrational decisions that stem from loss aversion, consider consulting a CERTIFIED FINANCIAL PLANNERTM professional from the Financial Planning Association who has the necessary experience and expertise to guide you.
FPA member David Zuckerman, CFP®, CIMA®, is Principal and Chief Investment Officer at Zuckerman Capital Management, LLC in Los Angeles, CA. He serves as CFP Board Ambassador and Director at Large for the Los Angeles chapter of the Financial Planning Association.
1Jason Zweig, Your Money & Your Brain (Simon & Schuster, 2007), 217-222