One of the reasons….why many of us lose money in the stock market….and how to fix it

Is your stock depository account is becoming like a ‘hospital’?
John purchased the stock of Ford Motor Company on 25th March 1999 priced at USD 32.50 per share. Today is 1st November 2019, the price is USD 8.89 apiece. For the last 20 years, John is waiting to make a profit (see chart below). He tried to sell it many times, but every time, he faced resistance from inside. The stocks are still lying in his depository account.

He, on the other hand, bought Google shares at USD 834.85 apiece on 10th Feb 2017. The share price climbed to USD 954.65 apiece on 19th May 2017, a whopping 59% (annualized return). Feeling very difficult to resist, he sold his entire Google stock. Only to haplessly observe later that the stock climbed to USD 1236.75 on 24th August 2018. (See chart below)

How many times you haplessly observed that the stock you have sold just now for a reasonable profit (at least, you think so…), thinking that the peak is already reached, didn’t stop climbing, and continues to reach new heights. But alas, you have already booked profits by then.
This was one side of the story. On the other hand, few shares that you bought several months ago (if not years) are still reeling under red. Not in the money, but you could not be able to gather enough stamina to book the loss by selling it. Waiting incessantly for the moment, hoping that someday the stock price would reach in the profit zone.
If you are facing this kind of scenario often, according to researchers, it’s happening because of psychological bias. Waber and Camerar (1998) termed this as disposition effect. In such a scenario, the stock depository account looks like a ‘hospital’, where only weak stocks are staying, healthy ones are all gone.
The ‘disposition effect’ is the tendency to sell assets that have gained value (‘winners’) and keep assets that have lost value (‘losers’).
Disposition effects can be explained by the two features of prospect theory: the idea that people value gains and losses relative to a reference point (the initial purchase price of shares), and the tendency to seek risk when faced with possible losses, and avoid risk when a certain gain is possible (Waber and Camerer, 1998).
What drives the disposition effect?
Zuchel, Heiko (2001) attempts to explain. According to him, the disposition effect is a special case of entrapment.
It is unclear, why people should underestimate the winning stocks (sell them early) and overestimate the losing stocks (retain them hopefully).
One explanation is of course prospect theory. It assumes that losses and gains are valued differently, and thus individuals make decisions based on perceived gains instead of perceived losses.
Another explanation is the regret theory. The theory states that people expect regret if they make the wrong choice, and they consider this anticipation when making decisions. Fear of regret can play a significant role in dissuading someone from taking action or motivating a person to take action.
Heiko (2001) considers the self-justification hypothesis (Staw 1976, Brockner 1992) as a suitable reason. The hypothesis says, individuals stick to a decision or course of action because they feel the need to justify or rationalize their decisions. This implies that the investors intend to hold the losing stocks because they are hesitant to admit that the past decision to buy the stock was wrong.
But….How you may avoid disposition effect?
A big question. The possible ways could be……
i) Practice the stop loss
If you are a trader, always put a stop loss on your investments. Decide the point, beyond which you will not be ready to bear the loss. For example, if your stop-loss is placed at 10%, and your investment is of USD 100, sale immediately, once it reaches USD 90, come whatever may.
ii) Enhance education and intelligence
Tarvo Vaarmets, Kristjan Liivamägi, and Tõnn Talpsepp (2019) demonstrated that higher intelligence and stronger learning abilities measured by education level and type of education reduces the disposition effect. Intelligent and highly educated investors also learn quickly. The suggestion is, enhance the learning ability if you want to avoid this kind of entrapment.
iii) Set your saving goals
Setting a defined savings goal may be a good way to remain unaffected from the disposition effect. Jaakko Aspara and Arvid O. I. Hoffmann (2015) demonstrated that the susceptibility towards disposition effect may be avoided by activating a superordinate (savings) goal. This can be activated by i) subtly prime it with goal-related words, (2) prime it by making an overall portfolio loss salient, and (3) prime it by explicitly mentioning a goal with a clear end state.
iv) Shift the feelings of personal responsibility
In another paper, Jaakko Aspara and Arvid O. I. Hoffmann (2015) again suggested that shifting the feeling of personal responsibility may again reverse the susceptibility to the disposition effect. They demonstrated that when investors possess some other socially demonstrated goals rather than only financial goals, they may reverse the effect.
So….next time…. If you get stuck with red marks in your depository account, do not wait…be ready for action.
Disclaimer: This article is written with an informative and academic objective. This should not be considered as a piece of investment advice. Please consult your financial advisor, before taking an investment decision.
