Don't cut the flowers and water the weeds

Billionaire investor and author, Peter Lynch, once confessed that the biggest mistake he made as an investor, was that he sold off his best investments way too early. He cites examples of when he sold his stock in Home Depot and Dunkin’ Donuts, just before each rose 20-fold.

Lynch said, ‘Selling your winners and holding your losers is like cutting the flowers and watering the weeds’.

Though Lynch humbly believes his errors were due to ‘dumb’ mistakes, another possible reason is a bias called the disposition effect. The bias was so named because people have a disposition to sell winners too early and ride losers too long.

The Disposition Effect

Let’s say you are planning an overseas holiday, and you need to sell some of your investments to pay for it. You own two different investments, one that has gone up 30% in value since you bought it, and the other that has gone down 30%. Which do you sell?

Study after study has shown that most people choose to sell the investment that has gone up in value.

The rational approach to the above scenario would be to assess the future of each investment and then decide which one has the better prospects, and then sell the other. But the disposition effect leads us down a different path.

The disposition effect is an anomaly in behavioural science whereby investors hold on to their losers (investments that have fallen in value), while selling their winners (investments that have increased in value).

So why do we do it?

In 1985, economists Shefrin and Statman, identified (and named) the disposition effect and gave several theories as to why it exists. The leading theory is that it is tied to prospect theory, which is a Nobel Prize winning idea by psychologists Daniel Kahneman and Amos Tversky.

Prospect theory shows us that people tend to avoid losses and optimise for sure wins.

If the sale of an investment is framed as a choice between giving yourself pleasure or causing yourself pain, we will usually choose pleasure. This means we’ll sell our winner and enjoy the pleasure of our ‘investment prowess’.

There is also a mental accounting aspect, where we see each investment purchase as a separate account, and we want to close each account as a winner. Hence, we keep our losers in the hope that they will recover and turn into winners.

The Cost

Selling just your winners can come at a cost. There is not only the missed opportunity of greater gains, but also you may be on the hook for Capital Gains Tax. However, selling losers may give you an opportunity to offset those losses against capital gains, thus reducing your overall tax burden.

Though it may appear harmless, the disposition effect can actually be hazardous to your long-term investing performance.

In a 1998 study, Berkeley economist Terrence Odean, examined the trading records of 10,000 individual accounts from a large US brokerage house over the period 1987-1993. He found that the average return of prior ‘winners’ that investors had sold, was 3.4% higher in the following year, than the average return of prior ‘losers’ that investors had kept.

Let Your Winners Run

Though there will be exceptions, in general, it pays to let your winners run. So, how should we navigate the decision on whether to sell our winners or losers?

The key is to always think in terms of intrinsic value, risk, and the future prospects of each investment. Work out which investment you believe has the better long-term prospects and keep that one.

Remember that ‘winning’ investments can always rise further and ‘losing’ investments can always fall further.

If, however, a stock you own gets caught up in hype and becomes excessively overvalued, then it may be a good time to unload.

The other option is to go somewhere down the middle, and ‘trim’ your winning holdings (or your losing holdings), and then reassess the situation down the track.