Why we can't let go of expensive stocks
If you've ever had trouble selling a stock - winners and losers alike - it's probably due to these two mental biases.
I took the bait. Last month, Amazon offered me a trial of its Prime service. I had bought from Amazon before, usually a few books and gadgets a year. Last month, though, I bought 14 items from the online retailer, ranging from kitchen scales to picture hooks. I don't know where I ordinarily would have bought this stuff, but I know I didn't buy it from Amazon before I had a Prime membership.
The lesson here isn't that Prime is bad – it was great. Some items arrived just six hours after I ordered them. The lesson is that Prime is a genius marketing ploy that plays on two powerful cognitive biases – the same two, I would wager, causing more portfolio mishaps than almost any other: Commitment and Consistency bias.
Commitment bias is the obvious one. If you're paying $99 a year for Prime, you should use it, right? We hate wasting resources and opportunities due to loss aversion, so we tend to focus on sunk costs, rather than make each new decision on its own merit.
Admittedly, having a Prime membership probably reduced the effort I put into shopping around for the best deals. Similarly, if a stock has been doing well for us, we tend to shop around less for the next bargain, preferring to stand by our earlier commitment.
In Too Much Invested to Quit, psychologist Allan Teger describes how this bias escalated commitment to the Vietnam War:
‘The longer the war continued, the more difficult it was to justify the additional investments in terms of the value of possible victory. On the other hand, the longer the war continued, the more difficult it became to write off the tremendous losses without having anything to show for them.'
A similar thought pattern develops when investing. A company may be flailing and its stock in free-fall, yet we continue to hold on, or even double down. We justify continued investment not despite prior losses, but because of prior losses. We hate the idea of letting go and having nothing to show for our ordeal, even if we consider the stock to be overvalued.
Would you like to renew?
Selling an overvalued stock is also difficult because we like to behave in a way that is consistent with our prior actions, which is known as consistency bias.
After we commit to something we tend to think up justifications for that commitment so that we feel we made the right choice. It's no surprise that Amazon Prime members tend to stick around and that their commitment escalates: 91% of first-time subscribers renew for a second year, and 96% renew for a third year.
Consistency bias is problematic in an investing context because it can cause us to stand by bad investments simply because we don't want to admit to ourselves – or others – that we were wrong. Research by the University of California found that investors are 50% more likely to sell winning stocks than those in the red.
In fact, merely owning the stock at all makes us reluctant to sell due to the endowment effect. Once a stock is in our possession it becomes ‘our' stock and we perceive it as special. We start telling our friends about the company's virtues, recounting the investment case dozens of times. Consequently, we usually feel the stock is more valuable than the current market price, so always want to hold on a little longer.
It's the classic Cinderella story. You fall in love with a stock, tell yourself ‘I'll dance just a few minutes more' … then the clock strikes 12 and suddenly you're knee-deep in pumpkins and mice.
To protect yourself from heartbreak, here are three helpful exercises.
1. Set the valuation criteria you require to sell a stock before you buy it and only move the goal posts for fundamental changes in your investment case, not merely a change in share price.
2. Consider the counter-arguments to your investment case. Why would someone be selling at today's price? Imagine that the stock collapsed, then ask yourself how and why this could have happened.
3. Come to your portfolio periodically and pretend that you have 100% cash, then ask yourself whether this is the set of stocks, at these weightings, you would want if you had to buy everything from scratch at current prices.
Doing these exercises won't eliminate commitment and consistency bias, but they should help to minimize blind loyalty to previous decisions.
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