In investing, no investor will ever be perfect; mistakes are a part of the process. Sometimes, bad investments will be completely beyond your control and have very little to do with the quality of your original investment decision (think China US trade war). Whether an error is attributed to a decision you made or something beyond your control, it doesn’t change the fact that you now own a poor investment and may need to cut your losses in order to get your portfolio back on track. As value investors we talk a lot about not selling investments just because they’ve gone down in value, and this will regularly be the advice we provide. With that said, there will be times when through careful analysis you will realize some of the investments you may own will have turned out poorly with little chance of recovery.
We should also mention that just because an investment has gone down in value, should not automatically give it the label of a bad investment. Every investor should understand markets will move up and down in the short term, often in a volatile manner. These up and down movements in the short term have more to do with public perception than they do with the actual fundamentals of the businesses you own.
For this article, let’s assume we do have a bad investment on our hands with little opportunity of recovery or future growth. Part of successfully saying goodbye to a bad investment is understanding the psychological forces that may be influencing you from not selling. Our psyche is riddled with behavioural biases that often prevent us from making the right financial decision. The better we understand these, the easier it’ll be to identify them in your decision making.
Let’s look at 6 cognitive and emotional biases that could be preventing you from cutting your losses and moving money into better investment opportunities:
Loss Aversion Bias– Through studies completed by Daniel Kahneman and Amos Tversky it was found that a person’s brain feels a loss approximately two times more than they feel a gain. This explains why so many investors struggle with selling out a losing position. The brain does everything in it’s power to avoid the pain of loss, even if it is the right decision. If you don’t sell, one can cling on to the belief there is still hope, and maybe you’ll be able to avoid a loss altogether; even in the face of information that suggests otherwise.
Conservatism Bias– People tend to overweight their initial reasoning or rationale behind a decision even in the face of new information. So even though there may be new information that materially changes your original investment thesis, conservatism bias may influence you to focus more of your attention on the original information discounting any new info that has surfaced.
Anchoring Bias– Similar to conservatism bias, investors anchor their future estimates to an original number in mind, even when faced with new information suggesting the original anchor is anything but an accurate approximation of the investments true value. Investors may hang on to a bad investment longer due to some number they have anchored to; whether it’s an analysts’ target price, your own target price, or the original purchase price of the stock; anchoring to a certain number affects your view of how the stock will perform in the future and clouds your ability to make an informed investment decision. If you’re saying to yourself “I’ll sell stock XYZ as soon at it gets back to $100”, chances are you’re anchoring.
Status-Quo Bias– This is a bias that suggests people prefer to stick with a prior decision than to have to go through the mental process of making another, even if the change puts you in position for a better long term outcome. Avoiding a change often feels like you’re not having to decide, although a basic understanding of “opportunity costs” suggests this avoidance is a decision in and of itself.
Regret-Aversion Bias– People tend to fear that the decision they make may turn out to be wrong in hindsight. For example, the fear of selling an investment just to see it rise in value after selling is a common concern I’ve heard among many retail investors who are trying to determine if they should exit a losing position. This is a prime example of regret aversion at work. Even though there is an equal or even increased chance the investment will go down further, the anticipation of feeling regret if the stock goes up afterwards can paralyze investors and cause them to not act, when in fact the evidence suggest they should.
Understanding the psychology behind how and when to “cut your losses” is a very important skill to develop that will surely help you better protect and grow your wealth. Creating wealth has A LOT to do with successfully allowing the effects of compounding to take place. By sitting on bad investments, you create drag on your portfolio’s overall average return, and on your ability to compound. Selling and re-allocating your money into other investment opportunities with better long-term prospects can help get your compounding back on track.
Although these types of psychological biases can be tough to identify on your own, you may after reading this notice some of them making their way into your own investment decisions. Being able to identify these biases will only help to increase your long-term performance.
- Brandt Butt, Investment Advisor
Brandt Butt is an Investment Advisor at award winning firm Endeavour Wealth Management with Industrial Alliance Securities Inc. Together with his partners he provides comprehensive wealth management planning for business owners, professionals and individual families.
This information has been prepared by Brandt Butt who is a Investment Advisor for Industrial Alliance Securities Inc. (iA Securities) and does not necessarily reflect the opinion of iA Securities. The information contained in this newsletter comes from sources we believe reliable, but we cannot guarantee its accuracy or reliability. The opinions expressed are based on an analysis and interpretation dating from the date of publication and are subject to change without notice. Furthermore, they do not constitute an offer or solicitation to buy or sell any of the securities mentioned. The information contained herein may not apply to all types of investors. The Investment Advisor can open accounts only in the provinces in which they are registered.