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Thursday, August 5, 2010
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."
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?