Prospect theory: selling winners, keeping losers

Investors have strong preferences to hold on to stocks that are selling below purchase prise so that could avoid being “losers”. Instead, they sell stocks that are selling above the purchase price, so they could come out as “winners” (Odean, 1998).

 

Goal To Make Money? Sell Losers

 

However, if your goal is to make money, the choice if to buy or sell the stock should be solely on how much you expect its value to increase in the future. The price at which you bought the stock is meaningless. Thus, it makes more sense to sell more losers than winners. To sum up, when investors seek to become “winners”, stock selection and taxes actually increase their chances of being losers.

 

Investors become more eager to sell their winners as the performance of investments improve. People are biased to sell winners. Decision makers tend to compare outcomes to a reference point. For most investors, the reference point is a price they have initially paid for the stock. Individuals who hold stocks valued at a price higher than they paid for them are faced with sure gains (selling now and becoming “winners”) or unknown returns (holding the stocks and risking the current gains).

 

Risk Averse and Risk Seeking

 

With high gains - we are risk averse. Individuals tend to sell to guarantee the gain. With loses - we are risk seeking. People hold stocks valued lower than initial purchase price. Investors tend to take risk of holding on to the loser in the hope of becoming a winner. 

 

Regret Minimisation Strategy

 

This is consistent with regret minimisation strategy - an effort to avoid “booking” a loss and feeling regretful. We let the “loss” ride, pretending it does not exist. If you sell the stock, mental accounting kicks in and you feel that you “lost”.

 

This pattern leads to lose of money relative to market’s overall performance. There are three reasons why regret minimisation strategy occurs: high costs associated with making trades, fear of selling wrong stocks, and paying too much in taxes. 

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