Maladies of get-evenitis and consolidatus profitus.

Get-Evenitis and Other Investor Maladies

By John Price, Ph.D.

What happens when you buy a stock and it drops by 30 percent? Do you sell or do you hang on hoping that it will come back to its original price? If you usually hang on, then you may be suffering from get-evenitis, a highly contagious disease particularly among males.

If you buy XYZ for $20 and it drops to $12, you now own a $12 stock. It does not matter how it arrived at this price. The question now becomes, "If I had $12, would I buy a unit of XYZ or would I buy something else?" If the answer is to buy XYZ, then hang on to it. Otherwise sell it. Unfortunately our ego will goad us into all sorts of rationalizations why we should not sell at a loss.

We want to be able to say, "It's only a paper loss. Don't worry. It will come back." Worse than having our teeth pulled is being forced to utter "I made a mistake." Even "There was a downturn in the market which caused XYZ to go south" is hard for most of us to say. Just as in real life, sometimes we have to face our mistakes and accept a loss before we can move on.

In 1995 Nicholas Leeson became famous for causing the collapse of Barings Bank, his employer. Over the previous years he had some serious losses. Instead of admitting them, in his own words, he "gambled on the stock market to reverse his mistakes and save the bank." But things just got worse and he ended up losing $1.4 billion.

It is unlikely that any of us are going to catch such an acute case of get-evenitis. More likely it will be a low-grade infection that eats away at our investing profits.

Get-evenitis has an associated disease called consolidatus profitus. Where you see one, you usually see the other. Sufferers of consolidatus profitus are often heard intoning "You can't lose money by taking a profit."

You may not lose money for that particular stock, but in the end what makes the difference is what we do with our profits. What if we put the money from the sale into a stock that is a major underperformer? We may be able to say that we made a profit on a particular stock. What we are not saying is that our portfolio went down because of the way we spent the profits.

If ABC goes from $20 to $30, then you now own a $30 stock. In the same way that you examined the loser above, think what you would do with $30. If you would buy ABC for $30, then keep the stock. If not, then sell it.

Of course, in real life things are a bit more complicated since we have to take into account transaction costs and taxes. But I think the general idea is clear-evaluate your stocks on what return you expect to get from them in the future, not on what they have done in the past.

Just how wide-spread are these diseases follows from a large-scale study carried out by Terrance Odean of the University of California in Davis. Reporting in the Journal of Finance, 1998, he found that people tended to trade out of winners into stocks that performed less well. Overall he found that people would have been better to sell their losers and keep their winners. Instead, they did the opposite, namely keep their losers and sell their winners.

To get a rough idea of the size of the losses, imagine an investor that has two stocks to sell, one a past winner and the other a past loser. Using data from Odean's study, the average return on the past winner over the next year was 2.4 percent above the market average compared to a 1 percent loss on the past loser.

This means that holding on to your winner would put you 2.4 percent ahead of the market during the next year. In contrast, holding on to the loser would put you 1 percent behind the market. But this is just what the average investor did. On average, investors choose to sell their winners more often than their losers.

The difference between the two strategies is even more marked when taxes are taken into account. When you claim a loss you are getting a tax rebate and so you want this as early as possible. In contrast, with a profit you are paying tax so you want to delay this as long as possible. But, as we just learned, the average investor tends to take profits early and losses late ending up on the wrong side of the taxman.

Actually, some investors are aware of these tax consequences. The above findings are actually for the months of January to November. In December, there was a slight tendency in the opposite direction with losers being sold more often than winners.

There are two primary explanations as to why investors sell winners more often than losers. The first explanation is what was described above, the aversion to having to admit that you made a loss is greater than the joy of being able to announce a success.

The second explanation is that investors generally believe in mean reversion for stock prices. This is the concept that over the longer term, stocks that go down will move back up to their original price whereas stocks that go up will come back down to their original price. Alas, if only the stock market was so simple. The results of Odean's study indicate that the opposite is more likely to happen, stocks that have gone up will go up even more, and stocks that have gone down will go down even more.

Of course, none of the above would come as a surprise to people familiar with the world of trading where the maxim "cut your losses short and let your profits run" is a basic tenet. In his famous book How to Make Money in Stocks, William O'Neil wrote, "If you want to make money in the stock market, you need a specific defensive plan for cutting your losses quickly and you need to develop the decisiveness and discipline to make these tough, hard-headed decisions without wavering."

The moral is to take a hard look at the stocks in your portfolio using objective criteria such as contained in Conscious Investor. Make your buy/hold/sell decisions on a careful appraisal of the profit you expect from them in the future and not on emotional attachment or pride. If you do this you will have inoculated yourself against the maladies of get-evenitis and consolidatus profitus.

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