Berkeley professor Terrance Odean points out that decisions to sell are not made in the same way as decisions to buy. As the market appears to be in a swoon, let’s explore this timely topic a bit further.
It’s relatively easy to manage winning trades. There is little stress and plenty of self-congratulation. Indeed, studies show that investors and traders quickly take credit for trades that have positive outcomes. Whatever stress one might feel typically comes from the fear of giving back gains. In strong bull markets, however, this phenomenon leads to a failure to prepare mentally and pragmatically for a potential downside.
Is ‘The Trend’ really your Friend?
In Fooled by Randomness, Nassim Taleb reminds us that “we are specifically designed by mother nature to fool ourselves.” Among the common ways we do this is to attribute our success to skill and our failures to chance. This means that we are unlikely to accurately assess our ongoing level of ignorance and develop appropriate methods for dealing with it. (If you doubt this, think back to the headlines of 2008.)
If it is luck rather than skill that accounts for the majority of trader gains during a strong uptrend, then few will be prepared to deal skillfully with the inevitable decline. Instead, these traders will be susceptible to a variety of self-deceptions.
The most common trap is known as the Disposition Effect, which is the tendency to view the intrinsic value and prospects of stocks we own more favorably than we would if we did not already own them. We easily rationalize holding on to losers by imagining a brighter future for the equity in question. We also want to avoid the possibility that 1) we sell for a loss, and 2) the stock then goes back up, which would make us feel doubly bad. (Didn’t we already do too much of that back in 2008?)
When we weigh these two possible future outcomes, it’s easy to vote for the one with the happy ending. To bring a bit more objectivity into the decision-making process, perform this simple mind experiment and ask yourself, what would you advise your friend to do with the same trade if it was his/hers, not yours. If you perceive a discrepancy between the two situations, then you’ve just awakened yourself from a dream.
