20 Jan, 2017

Greed and Fear – Disposition Effect

It turns out that there are specific names for the behavioural patterns that I have described in my earlier blog which you can read here. Over the next four blogs I am going to break down greed and fear into four specific behavior patterns which are also called behavioral biases.

The very first one is something we have all experienced and are guilty of. Everyone from Warren Buffett to a first time investor makes this. Holding on losers for too long and selling our winners early. Whereas we should be doing the opposite.

Why do we do that? We do it because we hate to accept our mistakes and a loss isnt a loss until you sell the stock. And we will do everything we can to put that away. And we keep hoping and hoping that a stock that we have bought and has gone into a loss, will atleast come back to break even. Sometimes it does and we hold on to that memory and forget that most of the times it does not. But humans have survived on hope and optimism but that does not work well in the stock market.

And why do we sell our winners early. Because we want to feel good and stoke our ego. We want to feel warm and fuzzy in our heart by seeing a winner in our portfolio and we want to lock that moment in. Fear of giving back profits sets in as soon as a stock goes into profit and every down tick is painful.

A stock owner goes through myriad emotions as price moves. The picture below illustrates this.

And it turns out that there is specfic name for this behavior pattern and its called the Disposition Effect. Researchers have traced the cause of the disposition effect to so-called “prospect theory”, which was first identified and named by Daniel Kahneman and Amos Tversky in 1979. Kahneman and Tversky stated that, “losses have more emotional impact than an equivalent amount of gains,” and that people consequently base their decisions not on perceived losses but on perceived gains.

What this simply means that losing Rs. 100 gives us more pain than the joy of gaining Rs. 100. It turns out that it takes twice the amount of gains i.e. Rs. 200 in the above example to offset the loss of losing Rs. 100.

And this happens to the best of investors. So know that when you fall prey to this behavior, you are not alone. But it so happens that you can train yourself to over come this or check youself when you become aware that you might be making this mistake.

Remember, it is not wrong to make a mistake, it is however wrong to continue holding that mistake and not taking action.

A simple rule to follow for your monthly/quarterly portfolio review would be: Keep winners, discard losers.

Important Disclaimer: Please do not treat anything on our blog as investment advice. We do not provide any recommendations of any stocks or securities. Any stock mentioned may be merely by way of an example.