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Thursday, August 5, 2010

Winners and Losers

Suppose you bought two stocks in 2007: Fannie Mae and Apple. Fannie Mae had a near monopoly on packaging mortgages to sell into the bottomless pit of demand for mortgage-backed securities. It was bumping along at $60ish/share. Apple had started the year at $85 and ended at $94. It had a reputation for coming out with "cool" products and being totally in tune with design. It did have the lingering questions of Steve Job's health.

We know the outcome. Today you need to tack on .ob to get a quote on Fannie Mae. It is trading as a penny stock around $.30/share. Apple, on the other hand, has gone on a moon shot in a very difficult market environment and is close to $250/share.

A big winner and a big loser. How would you have played it if you would have bought them? Everyone knows the dictum, first offered by a voice from the past: Edwin LeFevre- "Let your winners run and cut your losses quickly."

We have an indication of how the average investors handle winners and losers. Along with other evidence, Jason Zweig in "Your Money & Your Brain" reports that

"A look at more than 97,000 trades found that individual investors cashed in on 51% more of their gains than their losses - even though they could have raised their average annual returns by 3.4 percentage points (and cut their tax bills) if they had held on to the winners and dumped the losers."

Psychological Basis

Why do investors act exactly backwards and hold on to losers but grab profits too quickly? There's a psychological basis. Sell a loser, and the awkward possibility exists that it could immediately turn around - the mistake is compounded. In fact, anyone with any market experience knows the evil "Mr. Market" is lurking behind the bush just waiting for us to hit the sell button. Psychologically, taking action and it being wrong is more devastating than committing an error by not taking action. This is where the brain is playing tricks. So we hold on to the loser. The same effect takes place for our winners but in reverse. Taking a profit is a reward- a "pat on the back" as Zweig puts it. And we all like "pats on the back!" Especially when "Mr. Market" isn't being pleasant.

All of this is pretty much known by students of the market. What may not be appreciated quite as much is that the same behavior is likely at play when it comes to firing a poorly performing advisor. The same psychological factors are likely in play as clients hang on too long with poorly performing advisors and actively managed mutual funds for that matter. The possibility of making two bonehead moves is a restraining influence. And so both are held on to too long. At least that's my take. What's yours?


  1. I agree with your take. The temptation to take a little off the table is way too much for many investors. This is one reason why I like healthy dividend-paying paper assets. This automatically decreases some of the risk, even if leaving your money in the market is a bone-headed move (as you put it). Friendly Regards,

  2. I think you'll find this post interesting:

  3. Re: Shawn You are right about dividends should help people who make a boneheaded move although I have to admit I am not as big a fan of dividends as many on the blogoshere seem to be. I tend to favor companies that can put money to work and increase the value of the business.
    Re: Invest it Wisely I did enjoy the recommended post. TED talks are highly educational and I find that most of the presenters do a great job.
    Thanks to both of you for your comments!

  4. Can't say I haven't been self-victimized by the "I'll sell when I just get back to break-even" kind of thinking.

  5. If you can sell your losers without playing out a big psychological back and forth in your thinking it is a big positive!

  6. This might sound extreme, but I think there might be an argument for not selling anything ever.

    Take $5000 in Apple at, say, $60 a share.
    Take $5000 in Fannie Mae at the same price.

    Apple quadruples---Fanny goes to zero.

    The average smart person dancing around won't get the same return as the person who buys a bunch of stocks (or an index) and does nothing.

    In the above example, the lazy person makes out like a bandit. He/she loses $5000 on Fannie Mae, but reaps about $10,000 on Apple.

    When you hear about the "little old lady" who died with millions in her account, you often find that she invested like this: till death do you part with your stocks. Not listening to the "smart money" makes her rich.