In reality, we find it difficult to act in accordance with this stock market adage. Experience in the stock market shows that things usually go the other way around. Profitable investments are sold more often than those that are losing money. Why? Quite simply: Our perception evaluates profits and losses differently than our wallet does.
Classical economics assumes that investors assess gains and losses solely by comparing an investment's current value with its expected future value. Other reference points are considered irrelevant. So much for the theory. In reality, we perceive gains and losses quite differently. We determine whether an investment is in the black or in the red based on a reference point. This could be the purchase price, the most recent high, or our target price. If the current market value is lower than this reference point, we perceive a loss. If it is higher, we perceive a gain. If the reference point changes, so does our perception of profit and loss.
Why we are bad losers
In numerous experiments, Tversky and Kahneman demonstrated that we perceive gains and losses differently. In fact, the pain of losing 1,000 euros is about two to two and a half times as intense as the joy of gaining the same amount. This disparity is described by prospect theory, which offers surprising explanations for our behavior when it comes to investing.
From an emotional perspective, we react extremely rationally in the example described above. The joy of gains does not increase proportionally as profits grow. For example: We are very happy about a 20 percent gain. If the investment is held and the gain doubles to 40 percent, the joy of the gain changes only minimally. At the same time, the 20 percent gain could also be lost again. So why hold on to it? It is a valid question, because the greatest joy comes from realizing a profit quickly. It’s therefore difficult to let profits run.
Even when it comes to losses, our emotional behavior pattern is rational. Just as with the perception of gains, the perception of losses is not linear. Increasing losses cause less emotional pain. The pain of a 20 percent loss is clearly measurable. If this increases to 40 percent, the pain rises only marginally. Emotionally, we perceive a loss as such only when we realize it. As long as the investment remains in the portfolio, there is hope for a trend reversal and thus the possibility of recouping paper losses. Therefore, from an emotional standpoint, it makes no sense to sell when facing paper losses.
Acting emotionally and financially efficiently
Natural emotional behavior runs diametrically opposed to profitable investing. What can be done about it? A simple trick can help. Selling decisions should not be made based on comparative values, such as a target price or cost basis. Instead, ask yourself the following question: If I were not currently invested in this asset, would I buy it now? If the answer is yes, then hold the position. If your answer is no, then you’ve just given yourself a clear sell signal – regardless of whether you’re realizing gains or losses.
Financial psychology has many more fascinating insights to offer. And: Applying them will benefit your investments!
Author
Birgit Bruckner, MSc, CIIA
Independent consultant and trainer
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