Behavioural finance (a.k.a. behavioural investing) examines how psychological factors impact an individual’s investment decisions.
One likes to imagine that investors are rational creatures, but that is often far from the case. I find behavioural finance very interesting in how it explains certain, less logical, investing actions.
Today a look at how investors often keep their losing investments longer than they should.
The Wall Street Journal nicely summarizes “Why We Can’t Let Go of Our Losers”.
Research shows that investors often hold their losing investments longer than they should. Conversely, investors often sell their profitable assets more quickly.
For example, one study found:
“that individual investors are 50% more likely to sell a winning stock than a loser—even though, on average, the stocks these investors sell go on to outperform while those they hold onto underperform.”
The linked article provides additional research findings on investors holding their losers. As you may have guessed, behavioural finance helps explain why.
The article offers advice on dealing with losers. I have no problem with their suggestions, but I do not think they get at the heart of the issue. Namely, how to keep your emotions in check.
Humans are Emotional
Emotions play a big role in investment decisions. They should not, but they do.
I think a key to successful investing is developing discipline and objectivity.
Easy to say, difficult to achieve. But try your best.
One way to accomplish this is to create a written Investment Policy Statement. One that incorporates your investment objectives, personal constraints, and investment strategy. A well-planned, written document will aid in keeping you focussed, especially during periods of market volatility.
Make sure that it is written. I find that a written document is easier to adhere to than trying to keep your plan in your mind.
Is Not the Buy and Hold Approach a Problem?
Possibly. If you own a losing investment and hold it forever, you might end up keeping a dog.
That is why I prefer the buy and hold approach for well diversified assets, not individual stocks or poorly diversified investments. With diversified assets, the risk is spread throughout the holdings, thereby lowering the impact of any one loser.
With index funds, for example, you also have natural attrition within the index holdings. Over time, longer term losers within the index are deleted from the index. Not necessarily because they are losers, but because they have fallen in share price, market capitalization, etc. (this will vary based on index criteria) and no longer warrant being in the index.
Portfolio Review and Rebalance
It is also why you need to review and rebalance under a buy and hold approach.
The portfolio review should be an objective assessment based on current economic conditions and future expectations. As mutual fund prospectuses like to say, past performance is no indication of future results. You need to examine where an investment is going, not where it came from.
Based on the review and changes in economic conditions or your personal circumstances, you may need to rebalance the portfolio or make changes in holdings. Again, this should be an objective and disciplined process, based on your unique situation. It should not be predicated by emotions and getting caught up in market hype or by what you heard from a talking head on the financial channels.
Develop a formal approach to investing with an emphasis on your long-term objectives. Spend time (and possibly money for a financial planner) to create an appropriate investment plan that meets your needs. Then take a long-term perspective, tune out the short-term market noise, and adhere to the plan.
If you do, you will reduce the probability of letting emotions rule your investment decisions. And that may mean improved long-term performance.