I am sure most of us who have invested in the stock market been ‘burned’ by holding on to losers. The problem in investing is because we tend to attach our emotions towards our investments, be it stocks, commodities and etc. What happens next is that before you realized the value of your holdings had depreciated much almost close to zero.
We tend to hold on to our investments because there is always a hope that things will turned for the better and eventually we will be able to recuperate our investments. However I do have my fair share of bad investments and it never recuperated back to the price I paid with some of them totally wiped out. However it served as a lesson that I learned from the market which eventually helped me to avoid bigger losses as my trading career progressed.
Stocks or Commodities or any investment in particular are mere objects of possession. As an investor we shouldn’t place too much feelings or remorse towards them. We sell it when the price went up higher than we bought after comparing the ‘opportunity cost’ of investing in other ventures such as time deposits, paintings, real estate and etc. By right investments in stocks or commodities should be straight forward, buy when the risk/reward is attractive and sell them at higher prices.
However due to the marketing effort by the so called ‘stock jobbers’ and promoters that try to personify these investments and hence imbue human qualities into them. Hence they will associate stocks with emotionally attach words like ‘widow, retirement or orphan stocks’. As a result people tend to hold on to their stocks even though they are experiencing hugh losses.
As a result of holding on to stocks and refuse to sell we are subjected to the following psychological pitfalls which further alienate us from cutting our losses.
- Mental Accounting. By mental accounting we refer to a situation where we tend to hold on to an investment even though we know that there are better investments opportunities around. A good example will be a stock or real estate inheritance from our parents. Due to the sentimental value we place on such inheritance we don’t tend to either cut loss or sell it off so as to invest into something else.
- Sunk-Cost fallacy. Refers to a situation where we have committed some financial resources into an investment and sticking on to it even though better investments are available. An example will be the purchase of a ticket to a concert. We tend not to give it a miss even though it is raining heavily because we have already paid for the ticket. This will also affect our decision not to cut loss even though our investment turns out bad because we have already committed financially. In other words we tend to throw good money after bad investments.
- Endowment effect. This situation arises because we tend to place a greater value to something just because we owned it. We will tend to hold on to our stocks even though it had dropped 50% because we tend to believe that one day it is going to make a comeback. In one experiment where the researchers sold some movie tickets to the participants at $10 each and in return asked them how much they are willing to accept in order to part with their ticket. The prices range from $12 to $25 because they feel that they should be paid more for something they owned even though the price of the tickets are still going for $10 in the cinema.
In conclusion, in order to be successful in investing we need not only know how to have a strategy, good money management skills, able to read market through both fundamental and technical analysis but we also need to avoid both emotional and psychological traps that comes with any investments.
By ignoring these psychological pitfalls your road to success in investment will be confronted with many obstacles ahead because your portfolio will be burdened by many under performed stocks.