By Tudor Davies
Do you suffer from 'get-evenitis'?
Research shows that the shares people trade most frequently are those that have outperformed the market in the previous two years. They tend to retain their big losers, hoping to eventually break even.
Before understanding the reasons for 'get-evenitis' and possible solutions, it is first important to recognise if you display any symptoms.
Have you recently, or ever, said about a share or investment:
- it's only a paper loss
- I'll sell when it gets back to my buying price
- that share was good value at £1; I'm topping up as it must be a bargain now it's 50p
- the price will come back up again in time.
If the answer is yes, then you may well have experienced the ailment. It's called get-evenitis and it's caused by loss aversion. In other words the fear of loss is a more powerful driver of gambling and risk taking than the hope of gain.
Decision time
Consider the following pair of decisions and, without thinking too much, identify your preferred options.
Here is the first decision.
In addition to what you own you have been given £1,000. Which of the following options would you choose?
* A - A sure gain of an additional £500, or
* B - A 50% chance to gain a further £1,000 and a 50% chance to gain nothing.
Make a note of which you option you went for.
And here's the second decision.
In addition to what you own you have been given £2,000. Which of the following options would you choose?
* C - A sure loss of £500, or
* D - A 50% chance to lose £1,000 and a 50% chance to lose nothing.
What was your choice this time?
In fact, both decisions are identical in that the risk-averse answer (A or C) delivers a guaranteed result of £1,500 while the other option gives an equal chance of £1,000 or £2,000.
Most people are unwilling to gamble away a certain gain and choose option A for the first decision. In the second decision, when faced with a certain loss, most people are prepared to gamble to avoid that loss and they chose option D.
People hate losing, and the uncertain choice holds out the hope they won't have to lose.
Research shows a loss has about two and a half times the impact of a gain of the same magnitude. Not selling a losing share holds out the hope it may rise. It's called loss aversion. And it's hoping – not investing. And don't try to rationalise the decision with that old chestnut, reversion to the mean (simplistically, what goes down must go up) because it's seriously flawed thinking. Quite a few momentum investors would argue that what goes down, continues down and vice versa.
It gets worse
So the typical loss-averse 'get-evenitis' investor loses money by holding on to his losers.
However it gets even worse for the really badly afflicted. A study by Terrence Odean of the University of Southern California found that those who also sold their winners tended to trade into shares that performed less well over the medium term.
The research was clear: most investors are better off selling their losers and keeping their winners.
So, are rigorous stop-losses the answer?
Not necessarily. Stop losses work for some investors and not for others, and if they fit with your style of investing then fair enough.
What is important is to take a critical look at any share that goes down and re-appraise it.
In other words, you have to ignore the price you bought it for and evaluate it on the basis of its new price. A share you own may have been marked down along with the market, for no apparent reason. Or the share price decline may be associated with unexpected negative changes in its environment. The reason is irrelevant -- a re-assessment has to be made.
If your rational analysis leads you to conclude that the share remains good value then retain it (or buy more). But never retain it purely because "it was good value at £1, it must be a bargain at 50p". And of course the same applies to a winner. Make a rational assessment at the new price (which is what new buyers are doing) and take appropriate action. Never just bank profits, unless you have an alternative and more attractive investment.
Source:http://www.fool.co.uk
