NEW YORK (MainStreet) — Timing the market can be a foolhardy idea to partake in and often results in having retail investors keep their losing stocks while selling winners.
The phenomenon of loss aversion is hardly rare, and behavioral finance experts describe it as the "disposition effect," which is the “seeming irrational tendency of investors to sell winners and to hold onto losers,” said Robert Johnson, CEO and President of The American College of Financial Services in Bryn Mawr, Pa.
Every investor wants to accumulate a portfolio of winners rather than a portfolio of losers, but pulling the plug and knowing when to divest stocks has proven to be emotionally difficult to do. Investors can only blame themselves since their own “psychological biases get in the way of making rational investment decisions,” Johnson said.
Anchoring is a behavior that can lead investors to sell the "wrong" stocks, said Kimberly Clouse, chief client advocate at Covestor, an online investing marketplace with offices in Boston and London. When people are anchoring, they base decisions or estimates on events or values with which they are familiar, even though they may have no bearing on the actual event or value.
“It’s basically using irrelevant information as a reference point,” Clouse said.When investors believe in these fallacies, they wind up making poor financial decisions. If an investor bought a stock at $100 per share and the price falls to $80 because the financial situation at the company deteriorates for some significant reason, many will keep the stock. That's a tendency -- even against all rationality.
“Many people will tend to hang on to that stock and wait for it to reach $100, so that they can break even at the price at which it was purchased,” Clouse said. “They anchor the value of their investment to the value it once had and instead of selling it to realize the loss, they take on greater risk by holding it in the hope it will go back up to its purchase price.”
Successful investors are ones who can “leave their ego at the door and cut their losses short and let their profits run,” said Matt Tuttle, CEO of Tuttle Tactical Management, a Stamford, Conn. asset management firm. Following this strategy means you can only be wrong half the time and “still make a ton of money,” he said.
“Psychologically this is tough as it is fairly easy to take a profit, but it is very hard to sell something for a loss,” Tuttle said. “Investors convince themselves it is only a paper loss until they sell and once they sell it, it becomes real.”
Investors often wind up frustrated with stocks that have risen quite a bit and have begun to plateau, said Patrick Morris, CEO of New York-based HAGIN Investment Management.
“The anxiety of wondering if you're going to have to watch the stock retrace its entire gain is one the most investors are not willing to live with,” he said. “Once you start checking the price every day or several times a day, the urge to ‘book the gain’ will become quite overpowering.”
Eye on the Target
The other major issue which affects institutional as well as retail investors is that very few people actually have a price target in mind when they purchase a stock, Morris said.
“This is because whether it's a passion stock that you simply are falling in love with, a product that you know very well or if it's a well-researched fundamental idea, it can be very hard to determine exactly where the stock should go,” Morris said. “When you start a journey with no destination, it's hard to know where you're actually going. You don't know until your gut tells you.”
Hoping that a losing stock will “turn the corner and start moving in the right direction,” is another misconception, Morris said.
“It's much more depressing to reevaluate something that you were wrong about, so many people simply close their eyes to the situation,” he said.
Determining when your stock has reached a large enough decline for an investor to sell can be tricky. Investors should sell if they have held a stock for one year and it has dropped by 20%, said Morris. If you sell too soon, you risk locking in a lot of losses. Avoid constantly selling and buying stocks, because you could wind up losing money.
“Short-term losses only offset short-term gains, so unless you are planning on doing a lot of trading, it makes no sense to churn your portfolio,” he said. “Equities are volatile, so you need to have a risk appetite that matches the risk of the asset. In commodities, you have to be prepared for much deeper declines, maybe as much as 40% and 10% in bonds.”
Developing a sell discipline can be very difficult. Some investors will sell a position if it falls by some percentage, such as 15% of the purchase price. They establish stock loss orders at the same time they purchase the stock. If they buy the stock for $100 per share, they put in a stop loss order at $85 and this way they limit their losses to 15%.
"While that sounds great, in highly volatile markets these investors may get closed out of positions that are ultimately profitable," Johnson said.
A 15% market correction is not uncommon, and individual stocks are even more volatile. What investors need to focus on is whether the fundamentals such as a company's earnings and dividends have changed for the stock.
"If the fundamentals haven't changed, then what you have is akin to a 'sale' on the stock," he said. "A true value investor sees a dip in the stock price that isn't accompanied by changing fundamentals as a buying opportunity. It is ironic that in the stock market when a stock goes down in price, many investors considering purchasing the stock interpret that negatively."
Investors who keep losing stocks fail to notice the fundamental and technical indicators causing the drop, which inherently causes them to misjudge the potential downside, said Edison Byzyka, vice president of investments for Hefty Wealth Partners in Auburn, Ind. The same philosophy is followed by investors selling winning stocks.
One of the benefits of an advisor or an advisory service is to help cut through these biases so investors don’t impact their returns negatively, said Simon Roy, president of Jemstep, a Los Altos, Calif.-based software program which allows investors to link all of their current and previous retirement and brokerage accounts together.
Investors often hear the axiom that it is never wrong to take profits, which “feeds into the urge to sell,” said Donald Shelly, Jr., a professor of practice in the finance department at Southern Methodist University’s Cox School of Business.
“Regret also plays a part in selling winners, and this is especially true for investors who had early investing experiences where they saw a holding appreciate significantly, didn’t sell and saw the investment fall back or below their purchase price,” he said.
--Written by Ellen Chang for MainStreet