Kahneman and Taversky founded the field of behavioural economics. They claim that people act based on observable emotions. Many things flow from that and among them is the idea that losses hurt our feelings about twice as much as wins feel good.
Others believe that no human makes a rational decision. They make decisions based on what they feel and then find reasons to support them. Others have said that at the point someone makes a decision that matters, they are technically insane. Perhaps irrational would be easier to accept.
Whatever may be true, we cannot overlook being affected emotionally.
The idea of losses is a compelling feature. If I invest $10,000 in a stock and it shortly thereafter turns into $7,000, I will believe I have a loss of $3,000 even though I have not sold. If I don’t sell it could get worse or maybe go back up. What to do? No rational thought here.
In a different way, suppose the stock had gone up to $15,000 and then fell back to $12,000. Same $3,000 loss and guess what, I feel the same way. I lost $3,000.
Even more insidious is the case where I buy at $10,000 and sell at $15,000, but then the stock goes to $18,000. I lost $3,000. Losses are easy to feel.
There is no real issue with feeling losses unless you act on them. Action requires a higher standard than does the feeling bad part.
My rule is to make a decision to sell or keep on the same basis as I would a buy. What are the factors involved. Income, balance sheet, industry position industry growth prospects, competition, business position in the industry, market share, management, dividends, cash flow, accounting integrity and more. Find a range of value for the business. Finally consider the price offered by Mr. Market.
If Mr. Market offers stock for less than my value, then I should buy from him. If he wants more I should sell to him. Seems rational and also emotionally satisfying in a theoretical way.
We aren’t rational though. We have memory. My history will introduce emotions. If I should sell but I paid more than I can get, the decision gets harder.
It should not. The decision to keep a stock at a given market price is the same decision as to buy at that price. Either way you have the stock or the money. That’s rational.
Sometimes you have to adopt the Man From Mars Approach. Consider yourself to be a being who knows nothing of our history or our customs. All decisions observe objective reality this minute and rest on how that reality will affect the future.
I might have a stock that I think is fully priced now and on which I have a profit. It is December, if I sell I will soon owe taxes on the profit. I hold another with a loss that I would not buy if I did not own it. I hope it will go back up.
I should sell both and offset the profit with the loss. Since I would not buy either at the current price, my portfolio will be simpler. I will have cash to invest in better opportunities. All good.
When assessing paper losses and paper gains remember the rule. There are such things as paper profits, but all losses are real. Do your best to be objective.
Don Shaughnessy arranges life insurance for people who understand the value of a life insured estate. He can be reached at The Protectors Group, a large insurance, employee benefits, and investment agency in Peterborough, Ontario. In previous careers, he has been a partner in a large international public accounting firm, CEO of a software start-up, a partner in an energy management system importer, and briefly in the restaurant business.
Please be in touch if I can help you. firstname.lastname@example.org 866-285-7772