Avoiding The Avoiding Of Regret
Avoiding the emotional pain of regret causes you to sell winners too soon and hold on to losers too long. This causes a loss of wealth from taxes and a bias toward holding stocks that perform poorly.
How can you avoid this pitfall? The first step is to understand this psychological bias. This chapter should help you accomplish this step. Two other steps are helpful:
1. Make sell decisions before you are emotionally tied to the position.
2. Keep a reminder of the avoiding regret problem.
For example, when buying a stock for $100, you should decide at which price you will sell the stock if the price declines. You may decide to sell if the price falls to $90. However, making this decision before the price actually falls is not enough. You must act. You must act in advance, before the stock actually falls and regret starts to take place. How do you accomplish this? Place a stop-loss order. A stop-loss order is an order that tells the brokerage to sell the stock if it ever falls to a predetermined price. A stop-loss order at $90 will cause the stock to automatically be sold if the price falls to $90. This order is placed when the stock is still at $100 and regret has not had a chance to occur.
Another strategy is to make a point of selling enough losers to offset any gains that you might have incurred during the year. Although this can be done any time during the year, you probably feel most comfortable doing this in December. In fact, December is the most common month to take losses for tax purposes. Investors often use the end-of-the-year tax deadline as motivation to sell losers. However, losers can be sold at any time during the year to achieve the tax benefits. The reason that tax-loss selling usually occurs in December is that the closer you get to the end of the year, the tax-reduction motive has more influence over investors than the disposition effect.
Finally, keep a reminder of the avoiding regret problem. Consider how many futures traders train to do their jobs. Futures traders often take very risky short-term positions in the market. They can gain or lose large sums of money in minutes or even seconds. Some futures traders have told me that they memorized a saying:
You have to love to take losses and hate to take gains.
At first, this saying makes no sense. Why would you hate to take gains? The power of the saying is that it exactly counteracts the disposition effect. The avoidance of regret causes traders to want to hold on to losers too long. "You have to love to take losses" reminds them to sell quickly and get out of a bad position when the market has moved against them. Alternatively, the seeking of pride causes traders to sell their winners too soon. "Hate to take gains" reminds them to not be so quick to take a profit. Hold the winning positions longer than your natural desire for pride would suggest.
IN SUMMARY
To summarize this chapter, you act (or fail to act) to seek pride and avoid regret. This behavior causes you to sell your winners too soon and hold your losers too long. This behavior hurts your wealth in two ways. First, you pay more capital gains taxes because you sell winners. Second, you earn a lower return because the winners you sell and no longer have continue to perform well while the losers you still hold continue to perform poorly.
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