Selling
a stock at a loss is difficult for most of us because we have a loss
aversion bias. It is common for investors to want to break even on an
investment. Maybe you believe you should sell a stock but don’t because
it is lower that the price you paid.
Loss Aversion
Studies show people fear the negative effects of loss twice as
much as they enjoy the positive effects of an equal gain. In other
words, people have a strong tendency to avoid losses and allow loss
aversion bias to affect their investment decisions.
Myopic Loss Aversion
Myopic
loss aversion is the combination of being more affected by losses and
gains and the tendency to evaluate risk and outcomes too often. In other
words, investors have a tendency to be too nearsighted and make poor long term investment decisions because of short term loss aversion.
Example of Loss Aversion
Let’s
say Paul purchases a stock for $100 and three months later decides to
sell the stock due to a fundamental change in the company’s outlook. The
price of the stock is now $97. Like most of us, Paul doesn’t want to
take a loss so he decides he will wait until the stock reaches $100 so
he can break even and avoid a loss.
Let’s
look at Paul’s risk/reward ratio and see if it makes sense. His
potential reward for holding the stock is only $3 because he has decided
to sell at $100. Paul has decided to risk $97 for the potential of
making $3 more than he can receive today. Risk aversion bias has caused Paul to make a poor risk/reward decision.
Related Reading: Should the Price I Paid Affect My Decision?
If you have done your research and understand the intrinsic value of
the company, the price you paid for the stock should not have an affect
on your buy or sell decision. It is the current value compared to the
price today that matters.
Don’t
let loss aversion bias torpedo your investment returns. Forget about
what you paid when selling a stock at a loss. What you paid for an asset
has no bearing on the future price. Ask yourself; would this asset be worth buying now at today’s price? If not, sell it now!
http://arborinvestmentplanner.com/selling-stock-at-a-loss-and-our-loss-aversion-bias/
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