Successful investing necessarily includes the occasional stinker that didn’t fulfill its manifestly obvious potential. It is axiomatic that deciding what to buy is inevitably easier than culling out the losers. As the end of the year approaches, there may be compelling tax reasons for examining our reluctance to take our medicine and move on to the next sure winner. But it is worth noting that our brains are hard-wired to resist losses even when we know it is in our best financial interest. It is impossible to fully overcome our instinctive biases, but recognizing them is the key to improving investment performance.
Christopher A. HopkinsHuman beings almost always fall victim to a psychological trait known as loss aversion. In a nutshell, individuals generally place greater importance on potential losses than on the prospect of possible gains. We hate losing more than we love winning. Dozens of studies and behavioral experiments have validated this observation, which can be easily replicated with a coin flip. Suppose you are asked to toss a coin, given that heads means you lose $20. In order to play the game, virtually every participant would demand a greater payoff for tails than $20 to compensate for inherent loss aversion, even though the odds are exactly 50/50 for each flip.
When it comes to considering when to sell a declining stock and realize a loss, we must first overcome our instinctive distaste for accepting the fact that we made a bad decision. For investors in taxable accounts, the IRS even provides a little extra incentive to swallow hard and dump the turkeys we hold before the end of the year. That is because losses realized are actually assets that can help offset capital gains taxes on other positions sold at a profit. Even if you have no offsetting gains, you may still apply up to $3,000 in stock losses against ordinary income taxes. And unused losses may be carried forward into future years, in the event that you eventually buy a stock that goes up.
But even if you find unrealized losses in tax deferred accounts like IRAs, it still makes sense to do a gut check and consider dumping your underperforming positions unless you have a compelling rationale for holding on that has nothing to do with your purchase price. Hoping to get even without a supporting investment thesis that argues for holding the stock is an example of the psychological bias we are fighting to resist.
Say you bought 100 shares of Nile.com (the next Amazon) at $30 per share. Instead, it turns out to be the next MySpace and drops to $10. The brain’s survival mechanism kicks in and says “hold on until you break even.” Now consider an alternative perspective: suppose you are gifted $1,000 in cash. Would you buy 100 shares of Nile.com at $10 with your windfall? If the answer is no, you now have sufficient justification to dump the original stock, take a loss, and reinvest in something more promising.