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BW Businessworld

Calling The Shots, Right

You got to know when to hold them, know when to fold them, know when to walk away, and know when to run,” crooned superstar country and western singer Kenny Rogers in 1978. In doing so, Rogers might just have inadvertently dispensed a priceless piece of advice to investors about the importance of making rational “selling” decisions

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You got to know when to hold them, know when to fold them, know when to walk away, and know when to run,” crooned superstar country and western singer Kenny Rogers in 1978. In doing so, Rogers might just have inadvertently dispensed a priceless piece of advice to investors about the importance of making rational “selling” decisions.

After all, much has been said and written about how to make investments, but very little about how and when to successfully exit them. Just how many times have you made a great investment and exited too soon out of impatience or panic, only to sit on the sidelines regretting your decision, while it took off into orbit? Or conversely, locked your money in a losing stock far too long, while better opportunities passed you by, uncapitalised? If these actions sound familiar, it shouldn’t come as a surprise that there are not one but four major behavioural biases that are stubbornly standing in the way of your ability to exit your investments judiciously.

The first impediment to successful exiting is the “loss-aversion bias”. Put simply, investors, however experienced or seasoned, tend to be loath to losses. In fact, studies have indicated that investors hate losses somewhere between two and two and a half times as much as they enjoy making equivalent profits; implying that a loss of Rs 1 lakh will hurt you at least twice as much as the joy of gaining Rs 1 lakh. This bias can result in all kinds of irrational decisions, the foremost being the tendency to liquidate an investment hastily as soon as it slips into the red.

Here’s the catch: the tendency towards loss-aversion seems to be amplified by myopia, or an overt focus on the short term. For this very reason, individuals who check their investment portfolios too frequently run a much greater risk of making unsound exit decisions. Additionally, investors are able to stomach much larger price swings in more opaque asset classes (such as real estate or private equity), where prices are largely dictated by conjecture; compared to stocks, where prices are visible in real-time on a television screen. So the loss aversion bias can be conquered by the simple act of becoming more passive, tuning out of real-time market updates and checking your investment portfolio less frequently. A quarterly review of your investments will do just fine; anything more frequent could result in you becoming a trigger-happy seller.

There’s another dangerous obstacle to overcome on the road to successful exiting — the “disposition effect”. This is the mental bias that tricks investors into mistakenly believing that “a loss isn’t really a loss, until it has been booked or realised”. This fallacious belief leads investors to hold on to their losing stocks longer than warranted, and to sell their winning stocks a tad too soon. No prizes for guessing that this could lead to the rather unprofitable accumulation of ‘lemons’ in one’s portfolio over time.

Terrance Odean’s path-breaking research in this area culminated into an insightful 1998 paper titled “Are Investors Reluctant to Realize Their Losses?” After examining investor behaviours across 10,000 broking accounts, Odean discovered that individual investors are 1.7 times more likely to sell a winning stock than a losing stock! Talk about the perils of irrational decision making.

To fathom the nature of your other two behavioural nemeses, consider a make-believe scenario. It’s the year 2009, and encouraged by a slew of private equity investments into the stock, you purchase shares of K S Oils, then India’s largest mustard oil company, at Rs 50 a piece. Fast forward two years to 2011 and much to your annoyance, the stock is down 50 per cent, but you are still holding on for dear life (not an uncommon occurrence). While you step into the kitchen for a quick snack, your two-year-old son fiddles with your laptop keyboard and unwittingly dumps the stock on your behalf. What would you do in such a situation? Would you hurriedly buy back K S Oils at Rs 25? Strangely enough, when asked this question, almost nobody wants to buy it back. (In case you are curious, K S Oils is trading below Re 1 now).

The scenario thus described is a classic example of the combined impact of the “status quo bias” and the “endowment effect”. The former impeded you from breaking free from the status quo of holding onto K S Oils out of pure inertia, while the latter, rather interestingly, led you to attach a higher value to the stock just because you owned it. In other words, the endowment effect is what leads you to ascribe an often-ill-deserved degree of merit to investments that you own. When your toddler son “sold” the stock, you no longer owned it; and you could therefore, make a much clearer judgment call about it.

Behavioural biases are exceedingly hard to vanquish, but you could start by taking baby steps in the direction of becoming a more prudent “seller” of your investments. Don’t check your portfolio too often. Strictly assign premeditated stop-loss prices to your investments and adhere to them with discipline. Avoid holding on to stocks out of pure inertia. And lastly, reflect upon your investments based purely on facts and logic; as if evaluating something that you don’t currently own, thereby detaching the deadweight-value attribution arising from personal ownership. Admittedly, it’s no easy task; but if it were, wouldn’t we all be champion investors already?