Shrink Rap: A Recipe for Regret

Today, we have two questions that deal with the same issue, one that is relevant to large numbers of investors in the current market climate. It also happens to be one of the most common psychological hang-ups that investors face.

Dr. Hendlin, when trading (long- or short-term) I put what I know is way too much significance on the price at which I bought or sold a stock, and tend not to take an action confirming that a prior action was a screw-up (buying higher than I sold or selling lower than I bought). I am quite aware that this is not an intelligent way to think about things, and I occasionally overcome my reluctance to take such actions -- but probably would be a better trader/investor if this weren't a consideration at all. Any comments or suggestions?

-- D.K.

Dr. Hendlin, how come it's so difficult to sell a stock that's now at $5, when you paid $40 for it (and you don't believe that there's a chance in Hades that the stock is going to reach $40 again in your lifetime)? And why can't we sell it and get out when the $40 stock goes to $37? Thanks.

-- E.L.

Shrink Rap: The writer of the first question does not want to "confirm ... that a prior action was a screw-up." It is in the avoidance of this negative judgment that we find a clue to solving the puzzle. Here's the key: Psychology is powerful enough to condition our decision-making. Traders and investors are willing to incur financial pain to avoid emotional pain.

If you are a hard-nosed, "just-show-me-the-data" type of trader who believes that the "touchy-feely" world of psychology (what goes on in your mind) is too esoteric, nebulous or subjective to be of any value in the fast-paced world of trading, then you won't be too receptive to what I have to say next. But if you agree that our long-term biases and unconscious thoughts are sometimes the predominant factors in our decision-making, it is not a big stretch to accept these concepts.

Pride, Regret and Attachment

There is a long-term bias in our thinking that is called the disposition effect. The premise is that we are biased, or predisposed, to avoid regret and that we will behave accordingly. So we take actions like passively holding on to losing positions in order to avoid feeling the regret that goes with taking the loss by selling. The same bias also prompts us to sell our winners too soon, so that we may feel the pride that goes with making a gain.

You might ask, "But don't we already feel pain watching the stock drop so much?" Of course we do. But we feel financial pain more than emotional pain. The disposition effect suggests that we are willing to tolerate this financial pain more easily than the emotional pain (and negative self-judgment) that would register if we sold the position. We are able to rationalize (make excuses for) the losing position as long as we don't actually sell it. It is when we actually sell that we are forced to feel the full burden of regret. Good traders simply learn how to overcome this bias, tolerate the sting of regret and move on.

This tendency to avoid actions that will lead to feeling regret and take actions that will fill us with pride is sometimes mitigated by short-term market factors, such as panic reactions to get out of the market at any cost or tax-selling considerations. But this bias in our thinking helps explain why we won't sell the $40 stock when it hits $37 or even drops to $5.

Now, let's add one more consideration to help explain why we sometimes ride a stock down into the depths of Hell. That is attachment. Attachment to a stock gives us biased perception, meaning we view it in an overly positive light and filter out information that might interfere with our rosy picture.

Most long-term investors know how it feels to become attached to a company and its stock and develop an attitude of "my stock -- love it but never leave it." (Think "Dell-heads," 1995-99.) We delude ourselves that we need to hold the stock even when it proves to be a poor investment.

Shrink Rap's Secret Recipe for Loss and Regret

So here, then, is my recipe for riding down a losing position:

• Preheat unconscious mind to 400 degrees;
• Take 1 lb. bias to avoid regret and sprinkle with minced inflexibility;
• Add 2 1/2 cups attachment;
• Add 3 heaping tablespoons of poor risk management;
• Add 1/2 cup vermouth or dry white wine;
• Add 18 months of bitter bear-market seasoning;
• Allow to sit passively for months or even years;
• Remove from unconscious mind, add teaspoon of rationalization, cool for 15 minutes, and serve with banana slices. Garnish with mint sprig.

One way we avoid being seduced by this lethal recipe is to sell a position before we get attached to it or get hung up on our buy price. This means placing a stop-loss order as soon as we enter a buy position. Decide how much you are willing to lose, and then put in your sell-limit or stop-loss order at this point. It also means deciding how much you want to gain and putting in a limit order to sell at that price. This strategy guarantees that the disposition effect won't hamper your long-term investment goals.

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Topics for future "Shrink Rap" forums may include dealing with the pressures of trading; obsessive thinking; trading addiction; dealing with losses; perfectionist thinking; trader's block; improving concentration; neutralizing fear and greed; balancing isolation and information overload; and anything else that may be of concern to you. "Shrink Rap" appears on RealMoney.com every Wednesday. Be sure to send your queries to Dr. Hendlin at [e-mail].