Take, for example, holding on to poorly performing stocks. Instead of just accepting a loss and moving on, sometimes we hold on to these stinkers for a very long time. We can typically out this down to loss aversion, or regret aversion bias. None of us like the feeling of loss and will hold on to stocks as a gamble instead of selling. We do not want the feeling of regret associated with poor investment decisions, so investors hold on to poorly performing stocks too long so they don’t have to sell and acknowledge the poor investment decision.
Loss aversion theory argues that losses feel bad, and we take actions to avoid that dreadful feeling. For example, if an investor anticipates a loss, he or she will take less risk in the first place. There might be a connection here to one’s self-concept and wanting to avoid a sense of failure that could signal negative characteristic to oneself based on a poor investment.
What should you do: Two words (or a two-word hyphenate): Stop-loss
Place an order with your investment advisor to sell when an equity goes beyond a minimum value. This is designed to limit your potential losses. The losses will still feel bad, but not as bad as selling at an even lower value. Furthermore, the process becomes automatic. The pain of the decision, and acknowledging the failure, might be lessened by the fact that it was an existing agreement between you and your investment advisor.
Another typical case is Trend-chasing bias. We are social creatures and social norms influence us. We look to the pack for guidance, including looking at past success of the market, as well as our past personal successes.
The problem is that we are trying to beat the market, and looking at past successes and past choices of other investors likely won’t lead to getting in front. Trend-chasing bias refers to the practice of investing in top past performers because of the belief that past success predicts future performance.
We find in many cases that past success fails to keep up the same top pace. Familiarity bias compounds this, when investors continue to prefer well-known investments or sectors despite the well-known benefits of diversification. Investors may shy away from less-known areas of investment that are outside the comfort zone. Both of these can lead to suboptimal portfolio performance and more risk.
What you should do: Your homework
Overcome familiarity bias by learning more about less familiar investment options or industries. Rely on the guidance of your investment advisor who might be more familiar with the alternatives. If you find yourself following the beaten path, question it. Is it really the best option? Is it really less risky? Simply recognizing this tendency to want to repeat past paths to success might make you a wiser investor.
A final great example of investment irrationality is disposition effect bias. This is one of the most pervasive biases that hinders investment portfolio performance. We tend to frame our investments as successes or failures. Because of this, we tend to sell investments whose price has increased and keep those that have dropped in value. The former is because we might want to make up for a loss in another investment, the latter because we don’t want to acknowledge the loss.
Research shows that stocks that do well over 6 months tend to keep doing well, so selling because of strong performance well might be irrational as they might continue to increase. Similarly, stocks that underperform for a period of time also tend to continue at a loss, meaning there is no sense in keeping them.
With this information, it would seem that the rational choice would be to continue to hold top performances and sell underperformers; however, investors tend to do the exact opposite.
What you should do: Take a longer-term approach to gains
Zooming out on the performance trend graph might give you some clarity. Similarly, with underperformers, zoom out to get a better sense if this is a dip or a trend. Learn about the company’s initiatives for the future. Seek the advice of a trusted professional. Gather more information on the long-term. It might stop you from cashing out too early.
You need to feel comfortable with your investment decisions. Often we are told to trust our gut but behavioural economics suggest the gut might lead you astray. A combination of head and heart is best when playing on the market.