Loss-aversion tendency leads investors to avoid realising losses whereas risk-aversion makes them book gains too soon
By Mayank Joshipura
DO you suffer from a tendency to sell winners too early while holding on to losers for too long? If your answer is in the affirmative, then you are the victim of the disposition effect. But you are not the only one to suffer from such bad investment behaviour.
Legendary fund manager Peter Lynch also regretted selling his winning stocks too soon. In his famous book One Up Wall Street” he said, “Selling your winners and holding onto losers is like cutting the flowers and watering the weeds.”
Shefrin and Statman offered some of the early explanations for such irrational investment behaviour. Disposition effect results in small gains and large losses and consequently, inferior returns. In addition, the obvious adverse fallout is that investors end up holding a poor quality portfolio with a tax burden. Understanding what causes such irrational investment behaviour and how to avoid it would improve investment performance significantly. Following are the major explanations offered to explain disposition effect.
The Nobel Prize-winning Prospect Theory describes how we evaluate gains and losses while making choice under uncertainty. According to this theory, people are loss-averse and evaluate gains and losses with respect to a specific reference point. While people exhibit risk-averse behaviour in the gain domain and prefer certain gains over probable gains, they exhibit risk-seeking behaviour in the loss domain and prefer probable losses over certain losses.
Moreover, the sensitivity towards losses is more than twice as compared to gains. The purchase price is a natural reference point against which an investor evaluates gains and losses. The loss aversion leads investors to avoid realising losses whereas risk-aversion makes them book gains soon.
Think about an investor who is sitting on realised short term profit towards the end of the financial year. He also holds stocks in his portfolio with less than one-year holding period and which trades below his purchase price. Under such circumstances ideally one should go for tax loss harvesting by entering into a tax swap transaction. He should sell stocks with short-term losses and simultaneously buy substitutes or buy the same stocks as early as the next day.
This helps set-off short-term gains against short-term losses by incurring a small transaction cost and the tax burden as a result of that. However, it is easier said than done. An investor views each stock purchased separately, he creates a separate mental account for each stock and records gains and losses in their respective mental account individually for each investment and evaluates gains and losses with respect to purchasing price as the reference point.
This theory means booking loss in stock and buying its substitute in order to save tax. It is not a simple choice as it forces him to close a mental account for the stock at a loss and a loss-averse individual would find it difficult to do so.
Seeking pride & avoiding regret
An investor feels a sense of pride while selling stocks at a profit as it vindicates the correct investment decision, whereas closing a position at loss induces regret and the feeling of making a wrong investment decision. It is interesting to note that the feeling of regret is associated with realised losses and not paper losses. No wonder an investor is always keen to book profits but reluctant to book losses.
Lack of self-control
An investor who behaves in a disciplined manner in booking gains on hitting the target would generally fail to show the same discipline in booking losses and find several excuses for not doing so.
How to avoid it?
It is quite surprising that not only naïve investors but professional investors including fund managers succumb to the disposition effect. So if you are the victim of disposition effect and want to avoid it being a drag on the investment performance, you should keep your emotions in check and be disciplined in selling under-performing investments and continuing to ride winners (as long as they continue performing).
The writer is professor (Finance), School of Business Management, NMIMS, Mumbai