The behavioral economics of holding on to losing stocks

The rule in the stock market investment is simple: buy low and sell high. This makes intuitive economic sense. Of course, buying low and selling high is the only way to make a profit. Otherwise one would lose money.

However, it is not so straightforward because stocks are not static. They go up and down. To buy low often also means buying when a stock is going down and vice versa. The trouble comes when we paid this with our good old tendency of relying prediction of the future from the past. So translating this to buy low means buying when stock is going down (the past/future is glooming) and selling when the past/future. This changes the intuitive correctness of the rule. One could say that this is an emotional response (debatable), but conventional economists have long been aware of this and suggested a simple (no less easy to implement though) strategy: pre-set a price to sell (when it slides too low) and buy (when it rises to be beyond reasonable), then just stick to it. Leaving all potential emotional baggage out of the picture.

Economists would also caution against another consideration often hidden from our intuitive responses: opportunity cost. Opportunity cost does not necessarily mean any actual losses, but refers to the loss of other alternatives when one choice is made. In other words, it is the potential gain (cost) resulting from not switching from my current choice to an alternative (potentially better one). Translating this back to the stocks, what this means is a potentially profitable practice of selling a losing stock and using the fund released to buy a more promising stock to win back (cover) all the losses.

As an ammeter economist (I did economics and finance at university), I have tried to apply such a level of rationality: the ideal of an econ (borrowing Richard Thaler’s terminology in his famous 2008 book Nudge) who is guided purely by rational thinking and utility maximization, never disarrayed by emotions. Still, selling a losing stock (selling low compared to the price paid) to buy better ones to recover losses is hard to follow through. I would wait until the loss has bounced back and then sell, even with the smallest margin. Probably would have made more if I could swallow the loss and switch to a better-performing one.

But perhaps there is another reason for this human reaction (I am not econs after all). And this ties to work from another Nobel laureated—the late psychologist Danny Kahneman, about risk aversion and the level of certainty in the environment. According to this general tendency for the majority of us humans, we prefer sure gains and uncertain losses. In other words, given a choice between sure small and unsure large gains, we prefer the sureness; but for the losses, it is the opposite. We would gamble on unsure larger losses instead of sure smaller losses. Back to the stock market, selling losing stock to buy potential better ones is accepting a sure loss for uncertain gain. And we hate sure losses, no matter how small it might be. The potential alternative might be enticing, but it is just a potential, uncertain, therefore its lure is weaker.

We are, after all, only human.