A few weeks ago, I wrote herewithin about a natural phenomenon: When things go well, we tend to ascribe our success to our abilities—our disposition. But when they go wrong, we tend to blame external factors—our situation.
Finished. Done. Quick conclusion. Move on.
That type of quick conclusions means that not only are we unlikely to accurately assess our on-going level of ignorance, we are also unlikely to develop the appropriate methods to deal with it. Hence, we’d never learn very much.
So, if it’s luck rather than skill that accounted for the majority of investor gains during a strong uptrend, would we be prepared to deal skillfully with the inevitable decline?
Instead, many investors would be susceptible to a variety of self-deceptions.
The most common of these 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 didn’t already own them.
We easily rationalize holding on to losers by imagining a brighter future for the equity in question.
Moreover, we also want to avoid the possibility that 1) we sell for a loss, and 2) that the stock then goes back up, which would make us feel doubly bad. (Hmm, didn’t some of us already do a bit too much of that back in 2008?)
Therefore, when we weigh these two possible future outcomes, it’s easy to vote for the one with the happy ending. And, as a bonus, we’re more likely to sell winners than losers—a bad or at least not such a great choice!
To help bring a bit more objectivity into the decision-making process, choose this simple mind experiment and ask yourself what you would advise a friend to do with the same trade, if it was his/hers, and not yours.
Taking this “advice approach” may not be the best way to inject rationality into your decision-making (and it’s certainly not the only way), but I find it useful to imagine what advice we would give to another person, particularly someone we care a lot about.
What would also help is avoiding any tool that would highlight your purchase price (or your current gain or loss) against that purchase price. At least this would reduce the obviousness of that particular anchor, and thus mitigate its effect.
Incidentally, the reason I am able to write about this is not because I’m an expert; in truth, I seldom write about the things that I know. Instead, I write about the things that are deeply challenging for me right now.
“One half of the troubles of this life can be traced to saying ‘yes’ too quickly and not saying ‘no’ soon enough.” — Josh Billings, humourist