To Sell or Not to Sell, That Is the Question Most investors have to face loss aversion in their own investment portfolios when they incur losses. For long term investments the best course of action is to stay invested through the ups and downs of markets. But what if an investment is short term or has a limited investment horizon and the remaining time is shorter than the time needed to recover? Imagine that an investor has bought a specific stock with the intention of holding it for three years. In the first year, due to a string of bad news or a general market downturn, the share price falls by 20 percent. In order to break even after three years, the stock needs to have an average return of 12.5 percent per year over the remaining two years or even higher if the investor wants to make a sizeable profit over the entire three-year holding period. In many cases, stocks that have declined significantly are unlikely to recover over a short time, yet most investors refuse to sell a stock with a 20 percent loss or more. Instead they tend to hold on to it, and what started out as a short-term investment is mentally turned into a "long-term investment.
Topics:
Joachim Klement, considers the following as important: Investing, Investing money
This could be interesting, too:
Lance Roberts writes Yardeni And The Long History Of Prediction Problems
Michael Lebowitz writes The MACD: A Guide To This Powerful Momentum Gauge
Lance Roberts writes Exuberance – Investors Have Rarely Been So Optimistic
Lance Roberts writes Exuberance – Investors Have Rarely Been So Optimistic
To Sell or Not to Sell, That Is the Question
Most investors have to face loss aversion in their own investment portfolios when they incur losses. For long term investments the best course of action is to stay invested through the ups and downs of markets. But what if an investment is short term or has a limited investment horizon and the remaining time is shorter than the time needed to recover?
Imagine that an investor has bought a specific stock with the intention of holding it for three years. In the first year, due to a string of bad news or a general market downturn, the share price falls by 20 percent. In order to break even after three years, the stock needs to have an average return of 12.5 percent per year over the remaining two years or even higher if the investor wants to make a sizeable profit over the entire three-year holding period. In many cases, stocks that have declined significantly are unlikely to recover over a short time, yet most investors refuse to sell a stock with a 20 percent loss or more. Instead they tend to hold on to it, and what started out as a short-term investment is mentally turned into a "long-term investment."
Investors who bought technology stocks in the late 1990s or financial stocks in 2007 experienced losses that were much higher than the 20 percent given in the example above, but their loss aversion made them hold on to these stocks even though they originally had no intention of staying invested in these stocks for many years or even decades.
The Upside of Losses
Loss aversion leads investors to hold on to losing investments for far too long even if there is an incentive to sell losing investments. In the US and other countries, investors can use realized losses from one investment to offset and reduce capital gains taxes from other investments. This tax incentive gives rise to so-called tax-loss harvesting strategies that can help reduce tax burdens and increase after-tax returns.
Yet, loss aversion can be so strong that many investors prefer to hold on to losing investments instead of reducing their tax load. In a study of 10,000 brokerage accounts in the US, Terrence Odean found that individual investors are almost twice as likely to sell a stock that has a profit than to sell a stock that has suffered a loss. This leads to an average investment period of 124 days for losing stocks compared to 104 days for winning stocks for these short-term investments. As, in the short run, momentum effects imply that losing stocks will continue to decline in price while winning stocks will continue to rise, this leads to a significant underperformance of individual investor portfolios.