It’s the greatest trap in investing…
Most folks, when they start losing, can’t help but lose more.
It’s called loss aversion – and it’s one of the easiest ways to turn a “loser” into a “big loser.”
Loss aversion drives people to simply look away from losing positions. The impulse is so strong, people are prone to sell winners early and let their losers run – the exact opposite of what you should do as an investor.
Psychologists Daniel Kahneman and Amos Tversky first described it in the 1970s. The pair discovered how people feel more pain taking losses than pleasure booking similar-sized gains.
Since then, loss aversion has been studied and reported in financial and economic literature. It’s well-known. Yet it trips up educated and ignorant people alike. It’s very human. And if you’re not aware of it, you’ll lose thousands of dollars before you know it.
It’s related to a couple of other behavioral finance concepts as well: endowment effect and disposition effect…
Researchers know that once we buy something, we value it more. It’s as if the decision adds value to the object, above and beyond its worth the moment before we owned it.
This is true not just with stocks, but other things as well – clothes, art, cars, etc… That makes it twice as hard to sell something once we own it, especially if it turns into a loser. This is the endowment effect. We buy something, and it gains value.
The disposition effect is what keeps people from selling, even when they know they should. People “feel” that by avoiding the act of disposing of the investment (or thing), everything’s still OK. By not selling, we don’t have to realize the loss – it’s as if paper losses aren’t real.
But dispose of the stock, and the pain and bad feelings come flooding in. The brain doesn’t like those feelings. It can even make you physically sick…
Fortunately, once you learn a few simple techniques, managing losses is easy.
You can easily avoid loss aversion by using stops and position-sizing rules.
In my Retirement Millionaire advisory, we regularly recommend you use stops of 20%-25%. On most recommendations, we suggest “trailing” stops… As the prices run up from, say, $50 to $80, you’ll sell if the stock drops back down to $64 (20% stop) or $60 (25% stop).
Similarly, there’s position sizing. Never put more than 4%-5% in any one investment pick (single stocks and bonds).
The combined strategies of trailing stops and smart position sizing ensure you never lose more than about 1% of your portfolio on any one investment… Using a 5% position-size limit with a 20% stop, or a 4% size limit with a 25% stop works out to about 1% of your portfolio at risk.
I like to use Yahoo Finance’s e-mail price-alert function – which sends me an e-mail when a stock hits a certain point. (Another even easier way to track stop losses is with TradeStops. Click here to manage your investments the easy way.)
Most brokers offer a similar service… But whatever you do, I encourage you to avoid entering the order with your broker. That’s like playing poker, and telling everyone your hand. The effect is probably minimal at the size most of us transact, but I still avoid it.
Avoiding losses, however, is impossible to do…
Even the best investors have stories to tell about losses. The key is to learn how to limit the losses and avoid the paralysis of loss aversion.
Recognizing that it’s hard to take losses means setting up a plan for when losses appear.
And right now is a great time to “trick yourself” into thinking about losses in terms of future gains on your taxes. That can make it easier to face a portfolio with a lot of positions in the red.
For the losing positions that you sell before the end of the year, you can deduct up to $3,000 in booked losses on your 2016 taxes (and you can carry over additional losses to future years’ taxes). You’ll be putting cold, hard cash back in your pocket.
More important, you’ll be able to move on to better opportunities that are likely to outperform your old losers.
So if you haven’t done so already, look at your brokerage statement from last year to see if you booked any losses before year-end that you can claim on your taxes.
Ever had a position that you just couldn’t sell? Tell us how you finally forced yourself to do it by sending us an e-mail here.
What We’re Reading…
- Daniel Kahneman’s book Thinking, Fast and Slow is a great read about the behavioral biases that guide your brain and decision-making abilities. (You can get it in paperback for about $9 right now on Amazon.)
- Why people care more about losing a dollar than gaining a dollar.
- Something different: Training video on infantry guns and their effects from World War II.