Content provided by Paula Wieck, CLS Manager of Investment Research/Portfolio Manager
Ever go to a movie only to realize pretty quickly that it’s not going to be any good, but yet you stay and watch it anyway? In retrospect, you wish you would have left the theatre. Wasn’t it bad enough you wasted your money, but on top of that you wasted your time too? Why don’t we take our losses and move on?
We do the same thing with our investments. We look at our portfolios, find several investments at losses, and think, ‘They’ll come back – I’ll hold onto them until they do.’ We tend to think we are doing the right thing. There’s value in this investment, we tell ourselves; everyone else just doesn’t see it. In fact, we even tend to give ourselves a pat on the back for not selling and not following the herd like everyone else. We think we are demonstrating discipline by holding the investment until it recovers from its losses. Actually, we’re not disciplined at all. We’re loss averse. And being loss averse can be detrimental to our investment success.
Loss aversion is an emotional behavioral finance bias, identified by psychologists Daniel Kahneman and Amos Tversky, which suggests it is more painful to experience a loss than it is joyful to experience a gain. Because of this bias, we tend to hold onto losing investments too long and sell winners too quickly.
Think you may suffer from this bias? Here are a few questions to ask yourself:
- Do you hold investments longer than justified by rational investment analysis in an effort to break even?
- Do you tend to quickly sell securities that have appreciated for fear your profit will erode if you don’t lock in gains now?
If you think you are loss averse, here’s what you should do: re-evaluate your portfolio and its positions. Are the fundamentals and valuations still attractive? If you don’t know how to do this type of investment analysis, it may be time to hire a professional who does. It could save you precious time, money, and heartache.