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Cutting the Thought of Cutting Losses

As investors, we would assume that the decisions we make are rational and in our own interest.  But studies done in the realm of behavioural finance have shown how we (that is, humans as a group) are actually prone to making irrational financial decisions that are motivated by our emotions.  Such behaviour is called behavioural biases. A recent article with the headline Loss-averse, overconfident… that’s me: Set clear targets for cutting losses, on Singapore’s weekly newspaper publication The Sunday Times covered the bases.

One of the biases mentioned in the article was Loss Aversion, where we value gains to a much smaller extent than a loss of similar magnitude. Loss Aversion in particular, results in a peculiar behavioural bias known as the disposition effect.

The disposition effect is the tendency for investors to sell winning stocks and hold on to the losers because it is psychologically more ‘painful’ to acknowledge losses. This harms investors’ results because of opportunity costs whereby money invested in losing stocks can be put to better use elsewhere.

The article cited suggestions by students from Nanyang Technological University’s Nanyang Business School on mitigating the disposition effect – setting clear cut-loss levels. In effect, they’re saying investors should sell their stocks if it falls below a certain pre-determined percentage of their purchase price.

That looks good on first glance. But, it might not work out so well. Let’s see why.

Commercial-testing firm Vicom’s (SGX: V01) shares fell almost 30% from peak-to-trough ($1.90 on July 2008 to $1.36 on Oct 2008) during the global financial crisis of 2007-2009. Investors with clear cut-loss targets will likely have sold the shares upon the fall. But, its business was growing even during those difficult times as Vicom’s annual profit of S$15.8m in 2008 was actually 17% higher than the previous year’s.

If investors who sold out failed to repurchase shares, they missed out on a 250% return from the trough to today’s price of $4.81, as Vicom’s shares eventually reflected the company’s fundamentals.

Retailer Dairy Farm Holdings (SGX: D01) was another example that saw its share price plummet by almost a third from the peak of US$5.68 on June 2008 to the bottom of US$3.75 on Oct 2008. It was also another company whose revenues and profits were unaffected by the global melt-down – annual sales grew 14% year-on-year to US$6.73b while profits increased by 29% to US$333m.

And investors who sold out due to that fall missed out on a 240% return with Dairy Farm exchanging hands for US$12.70 apiece.

We could go on, but you get the idea. The point is: selling out on a share just because its price has fallen can be a bad idea. Instead of basing buying-or-selling decisions on the movement of a share’s price, perhaps investors should focus on the evolution of the business underlying the share instead.

Before any investment is even made, jot down business-based reasons that would make you sell a company’s shares. During any price declines, check back on how the business is faring. If those reasons-for-selling aren’t met, then keep calm and carry on. If those reasons are met, then exercise discipline and sell them. That way, the disposition effect gets taken care of, and the risks of selling shares in a business that’s still going strong is lowered.

At the Motley Fool Singapore, we believe that investing in the stock market should be based on the evaluation of businesses – don’t let the price action of a share alone determine what you do with it.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore contributor Chong Ser Jing doesn’t own shares in any companies mentioned.