Anyone who has invested in a stock has surely experienced a loss, but have you ever bought into an investment that seems destined to be a loser? I’m sure there are plenty of us out there who have bought a stock and almost immediately the value has fallen. We hold on to it thinking it will come back, but months go by and the value stays below the purchase price. So we wait and we wait, refusing to acknowledge that we bought into a stock at an inflated price and now the market refuses to value it at the price we paid. So what do you do?
There are really only two things to do, and on the surface the choice seems relatively simple, especially from an objective standpoint. One option is to hold it and continue to wait for the price to come back up. The second option is to cut your losses and find something else. I imagine that from this impartial viewpoint many of us would simply say, sell it and get something else, but when it was our decision to buy the stock and our decision to sell, it isn’t quite as cut-and-dried as that. When it is our own stock, our own decision, and our own emotions it can often be much more complicated than a simple buy-sell decision. Let me explain.
Daniel Kahneman, noted psychologist and co-developer of Prospect Theory which earned him a Nobel prize, states that “we refuse to cut losses when doing so would admit failure.” So, I could stop here and say that because we do not want to admit to ourselves, or others, that we chose a loser investment, we would rather hold it in hopes that it will someday make us a profit and we can admit victory! In the meantime, there is a world of other potential investments that increase in value as the losers languish. Regret, however, is a powerful emotion that will blind us from making proper decisions because it is a painful punishment for acknowledging a mistake of lost opportunities.
The Disposition Effect
As we go through life, we set up mental accounts in our brain. For every stock that we buy, we establish an account for that stock. As time goes on, we make mental entries into the ledgers that correspond to each account. For the stock accounts, we mentally note that some have increased in value – winners! And some have decreased in value – losers. As rational beings, we are supposed to evaluate information and make decisions that increase our utility – whatever that is. But, as humans with emotions, we don’t always act as rational beings. Studies have shown that if a person has two stocks – one a winner and one a loser, rather than evaluating the stocks on their fundamental ability to generate investment returns in the future, a person will often only evaluate the decision to sell a stock on whether they have a gain or a loss. Mentally, I’ll bet you already chose to sell the winner rather than the loser. Whether or not that is a good decision truly only depends upon what each stock is expected to do going forward.
In the United States we have a difficult and convoluted tax system. I hate our tax system and I could make the decision to immediately do away with it and replace it with something else, I would. But as it is, there is at least one bright spot to the convoluted system of punitive taxation in America – the capital loss deduction. Most investors also are aware that there is also a capital gain tax. With this, if you are to sell a loser you get to offset capital gains and even some portion of ordinary income, thereby reducing the amount Uncle Sam confiscates from you! On the other hand, if you sell a winner, Uncle Sam is going to reach his greedy little hands into your pocket and take his unfair share of your earnings at the tune of 15- or 20-percent! That means that if you sell an investment with a $1,000 gain, you may have to fork over $150 or $200 to the IRS, thereby, reducing your actual gain to $800 to $850. Depending upon your ordinary income tax rate, a loss could be much more valuable. At 39.5% (the top marginal tax rate) a $1,000 loss could be worth $395. This equates to only a $605 actual loss!
I could go on and on recounting the mental complications we make for ourselves when making decisions on whether or not to sell a losing stock. The point I am trying to make here is that it isn’t always as simple as we think it is. It’s not a yes-no, black-white, on-off decision that we can accurately make for ourselves because of our emotional state of being. This is yet another reason why it is wise to hire a professional to help manage your financial life. A professional, especially one who has studied the complex emotions that come into play, is invaluable in helping to create wealth.
I first heard a presentation on behavioral finance and Neuroeconomics at a Morningstar convention in Chicago in 2008, and ever since I have been an avid consumer of information on this subject. The amazing thing about this topic is that regardless of who you are, or where you come from, emotion affects your rational decision making. Furthermore, most of us are clueless to this fact until it is pointed out to us. We think that we make rational decisions regarding our investments, finances, or other money concerns, when in reality our decisions are often the result of incomplete information guided by our veiled emotional state.