Seeking Pride and Avoiding Regret
People avoid actions that create regret and seek actions that cause pride. Regret is the emotional pain that comes with realizing that a previous decision has turned out badly. Pride is the emotional joy of realizing that a decision has turned out to be a good decision.
Say you've been playing the lottery.
You have been selecting the same lottery ticket numbers every week for months. Not surprisingly, you have not won. A friend suggests a different set of numbers. Do you change numbers?
Clearly, the likelihood of the old set of numbers winning is the same as the likelihood of the new set of numbers winning. There are two possible sources of regret in this example. Regret may be felt if you stick with the old numbers and the new numbers win, called the regret of omission (not taking an action).
Alternatively, regret would also be felt if you switch to the new numbers and the old numbers win. The regret of an action you took is the regret of commission. In which case would the pain of regret be stronger? The stronger regret is most likely from switching to the new numbers because you have a lot of emotional capital in the old numbers - after all, you have been selecting them for months. A regret of commission is more painful than a regret of omission.
DISPOSITION EFFECT
Avoiding regret and seeking pride affects people's behavior, but how does it affect investment decisions? This is called the disposition effect.
Consider the situation in which you wish to invest in a particular stock, Lucent. However, you have no cash and must sell a position in another stock in order to buy the purchase it in the nrst place. You enjoy pride at locking in your profit. Selling Microsoft at a loss means realizing that your decision to purchase it was bad. You would feel the pain of regret. The disposition effect predicts that you will sell the winner, IBM. Selling IBM triggers the feeling of pride and avoids the feeling of regret.
It's common sense that because of this you may sell your winners more frequently than your losers. Why is this a problem? One reason that this is a problem is because of the U.S. tax code. The taxation of capital gains causes the selling of losers to be the wealth-maximizing strategy. Selling a winner causes the realization of a capital gain and thus the payment of taxes. Those taxes reduce your profit. Selling the losers gives you a chance to reduce your taxes, thus decreasing the amount of the loss. Reconsider the IBM/Microsoft example and assume that capital gains are taxed at the 20% rate. If your positions in Microsoft and IBM are each valued at $1,000, then the original purchase price of IBM must have been $833 to have earned a 20% return. Likewise, the purchase price of Microsoft must have been $1,250 to have experienced a 20% loss. Table 5.1 shows which stock would be more advantageous to sell when you look at the total picture.
If you sell IBM, you receive $1,000, but you pay taxes of $33, so your net gain is $967. Alternatively, you could sell Microsoft and receive $1,000, plus gain a tax credit of $50 to be used against other capital gains in your portfolio; so your net gain is $1,050. If the tax rate is higher than 20% (as in the case of gains realized within one year of the stock purchase), then the advantage of selling the loser is even greater. The disposition effect predicts the selling of winners. However, it is the selling of losers that is the wealth-maximizing strategy!
This is not a recommendation to sell a stock as soon as it goes down in price - stock prices do frequently fluctuate. Instead, the disposition effect refers to hanging on to stocks that have fallen during the past six or nine months, when you really should be considering selling them. This is a psychological bias that affects you over a fairly long period of time. We'll discuss a similar, but opposite behavior in the next chapter, one that happens very quickly - where there is a quick drop in price and the "snake-bit" investor dumps the stocks quickly.
SELLING TO MAXIMIZE WEALTH
SEEKING PRIDE AND AVOIDING REGRET
DO WE REALLY SELL WINNERS?
So, do you behave in a rational manner and predominately sell losers, or are you affected by your psychology and have a tendency to sell your winners? Several studies provide insight into what investors really do.
One study examined 75,000 round-trip trades of a national brokerage house. A round-trip trade is a stock purchase followed later by the sale of the stock. Which stocks did investors sell - the winners or the losers? The study examined the length of time the stock was held and the return that was received. Are investors quick to close out a position when it has taken a loss or when it has a gain? Figure 5.1 shows the average annualized return for positions held 0-30 days, 31-182 days, 183-365 days, and over 365 days. Figure 5.1 indicates that investors are quick to realize their gains. The average annualized return for stocks purchased and then sold within the first 30 days was 45%. The returns for stocks held 31-182 days, 183-365 days, and over 365 days were 7.8%, 5.1%, and 4.5%, respectively.
It is apparent that investors are quick to sell winners. If you buy a stock and it quickly jumps in price, you become tempted to sell it and lock in the profit. You can now go out and seek pride by telling your neighbors about your quick profit. On the other hand, if you buy a stock and it goes down in price, you wait. Later, if it goes back up, you may sell or wait longer. However, selling the winner creates tax payments!
ANNUALIZED RETURN FOR DIFFERENT INVESTOR HOLDING PERIODS.
This behavior can be seen after initial public offering (IPO) shares hit the market. Shares of the IPO are first sold to the clients of the investment banks and brokerage firms helping the company go public. As we will discuss in detail in the next chapter, the price paid by these initial shareholders is often substantially less than the initial sales price of the stock on the stock exchange. These original shareholders often quickly sell the stock on the stock market for a quick profit - so often, in fact, that it has a special name: flipping IPOs. There are times, however, that the IPO does not start trading at a higher price on the stock exchange. Sometimes the price falls. The volume of shares traded is lower for these declining-price IPOs than for the increasing-price IPOs. The original investors are quick to flip increasing-price IPOs, but they tend to hold the declining-price IPOs hoping for a rebound.
Another study by Terrance Odean examined the trades of 10,000 accounts from a nationwide discount brokerage. He found that, when investors sell winners, the sale represents 23% of the total gains of the investor's portfolio. In other words, investors sell the big winners - one stock representing one quarter of the profits. He also found that, on average, investors are 50% more likely to sell a winner than a loser. Investors are prone to letting their losses ride.
Do you avoid selling losers? If you hear yourself in any of the following comments, you hold on to losers.
SEEKING PRIDE AND AVOIDING REGRET
■ The stock price has dropped so much, I can't sell it now!
■ I will hold this stock because it can't possibly fall any farther.
Sound familiar? Many investors will not sell anything at a loss because they don't want to give up the hope of making their money back. Meanwhile, they could be making money somewhere else.
Selling Winners Too Soon and Holding Losers Too Long
Not only does the disposition effect predict the selling of winners, it also suggests that the winners are sold too soon and the losers are held too long*.
What does selling too soon or holding too long imply? Selling a winner too soon suggests that it would have continued to perform well for you if you had not sold it. Holding losers too long suggests that your stocks with price declines will continue to perform poorly and will not rebound with the speed you hope for.
Do investors sell winners too soon and hold losers too long, as suggested by the disposition effect? Odean's study found that, when an investor sold a winner stock, the stock beat the market during the next year by an average of 2.35%. In other words, it continued to perform pretty well. During this same year, the loser stocks that the investor kept underperformed the market by -1.06%. In short, you tend to sell the stock that ends up providing a high return and keep the stock that provides a lower return.
So we've seen that the fear of regret and the seeking of pride hurts your wealth in two ways:
■ You are paying more in taxes because of the disposition to sell winners instead of losers.
■ You earn a lower return on your portfolio because you sell the winners too early and hold on to poorly performing stocks that continue to perform poorly.
React to a news story? Buy, sell, hold? I examined the trades of individual investors with holdings in 144 New York Stock Exchange companies in relation to news reports.5 I specifically studied investor reaction either to news about the company or to news about the economy. News about a company mostly affects the price of just that company's stock, whereas economic news affects the stock prices of all companies. The results are interesting. Good news about a company resulting in an increase in the stock price induces investors to sell (selling winners). Bad news about a company does not induce investors to sell (holding losers). This is consistent with avoiding regret and seeking pride.
However, news about the economy does not induce investor trading. Although good economic news increases stock prices and bad economic news lowers stock prices, this does not cause individual investors to sell. In fact, investors are less likely than usual to sell winners after good economic news. Investor reaction to economic news is not consistent with the disposition effect.
This illustrates an interesting characteristic of regret. After taking a stock loss, investors feel stronger regret if the loss can be tied to their own decision. However, if the investor can attribute the loss to things out of his or her control, then the feeling of regret is weaker. For example, if the stock you hold declines in price when the stock market itself is advancing, then you have made a bad choice and regret is strong. In this case, you would avoid selling the stock because you want to avoid the strong regret feelings. Alternatively, if the stock you hold drops in price during a general market decline, then this is divine intervention and out of your control. The feeling of regret is weak and you may be more inclined to sell.
In the case of news about a company, your actions are consistent with the disposition effect because the feeling of regret is strong. In the case of economic news, you have a weaker feeling of regret because the outcome is considered out of your control. This leads to actions that are not consistent with the predictions of the disposition effect.
http://www.wdc-econdev.com/THE-INVESTMENT-ENVIRONMENT/emodons-rule-investment-banks.html
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