We’ve all been there before… we open our portfolio statement and see a holding has gone down. Maybe just a little bit, or maybe more than just a little bit. We decide to hold on. Next month’s statement arrives and the holding is down some more. Again, we decide to keep it. Another month goes by and the same story. Then another one… and another one. One more after that.
This kind of naughty investor behaviour is so common it’s got a name: The Disposition Effect. It’s defined as the tendency of investors to sell shares that have gone up in price, but hold shares that have dropped in value. It defies common sense, and is one of the primary reasons for significant underperformance by experts and amateurs alike. In contrast, winning investors do exactly the opposite; they keep winners and sell losers. Not only does that increase portfolio gains, but it also adds a layer of tax efficiency for Canadian investors. So if the Disposition Effect is so irrational, and we know it’s bad, why does it happen so often?
In 1968 two researchers at the University of British Columbia published a study about the behaviour of bettors at a race track. They found that prior to making a $2 horse bet, bettors felt a “fair chance of winning.” However, when those same bettors were asked again how they felt after placing their bets, they indicated a “good chance of winning.” The bettors’ confidence increased from “fair” to “good” even though nothing had changed except for them placing their bets. Could this false sense of confidence be the same reason investors hold losing stocks? Is there something about holding a losing stock that let’s hope trump common sense? It turns out, yes. Most investors are unwilling to accept a loss because losses bruise confidence and challenge ego. Once you sell below a purchase price, you can never hope for a comeback and never regain illusory guru status.
Holding losing stocks, then, is not about economic loss. It’s about emotional loss. Most investors are afraid to lose because it feels like admitting to a “bad” decision. But what separates talented investors is the mindset that it’s not about feeling good or bad. It’s about dealing with losses professionally and appropriately. True talent recognizes good and bad is irrelevant in the markets, and that the real contest is between skill and luck.
As long as an investor consistently applies skill, and is occasionally unlucky, long term performance will shine. However, if an investor allows losses to compound, they are depending on luck to save them, which obviously lacks long term winning potential.
Relying on a defined systematic investment process is the only way investors can remove the right and wrong of ego and ensure success.
Ben Kizemchuk is a Portfolio Manager & Investment Advisor with Altus Securities Inc. in Toronto. He offers financial planning and investment management for high net worth Canadian investors. Ben focuses on high quality investments, the Growth and Income Portfolios, low risk investing, and reducing tax.