Have you ever wondered why it is that people (including myself) tend to accumulate “stuff” in their basements and attics? You know the stuff I mean – old furniture, clothes, boxes full of whatever from when you moved 15 years ago that you were sure you’d need again someday. How about some losing investments? Why don’t we just get rid of it? The answer lies in a well-researched psychological trap called “loss aversion.”
Studies have shown that the pain of a loss is almost twice as strong as the reward felt from a gain. The emotion of loss is a very powerful negative emotion and causes us to put too high a value on things that really aren’t worth that much. Hence, we’ve got stuff.
The same aversion to loss occurs in a number of forms in the investment world.
One is the tendency to hang on to losing investments. It’s not uncommon for me to see investors with holdings that are down 60, 70, 80 and even 90% from where they were when purchased. By ignoring the fact that the investment was a bad one and not selling, the pain of loss is avoided while the realities of loss are mounting.
Loss aversion also leads investors to focus too much on negative results and not take a holistic view of an entire portfolio. For example, if in a portfolio of twenty stocks all but a few are up in value but those few that aren’t are in the red, loss aversion leads most investors to focus almost exclusively on the loss and make overly-conservative decisions going forward. It’s a vicious cycle in which the risk of loss leads to the risk of being overly cautious; both of which can be financially detrimental.
So how do you avoid falling into the loss aversion trap? It’s not easy but start with the simple mantra of “letting your winners run, and be quick to sell your losers.”
Because it’s impossible to invest without having the occasional losing pick (or two or seven), I recommend utilizing trailing stops on your investments. Trailing stops are simply pre-determined percentages at which you sell your investment. By setting trailing stops when you buy an investment and hopes are high rather than when you’re feeling the potential pain of loss, you can be more rational and less emotional in the setting. The exact percentage you set in not as important as following through with the sale when the stop point is hit. Set it and follow it. No matter what your heart says.
In much the same way you might seize this time of year as a time to get your house in order, I encourage you to get your finances in order, too. Either on your own or with your financial advisor, review your investment “stuff.” Take a good hard look at what you’ve got and get rid of what’s not working. Try to keep emotions out of it and focus on the real usefulness of what you have. Is it contributing to your financial goals? If not, get rid of it. And for the stuff you do decide to keep, set trailing stops. This small effort will make it easier to part with that which is not working in the future and maximize the potential of what is.