Much of what I have observed with regards to investor behaviour over time tells me that there are some bad practices and habits which seem to persist, despite investors knowing better. It is similar to smoking or binge drinking – everyone knows that they are bad activities and should be avoided, but people can’t help succumbing to them.
One particularly rampant practice I have witnessed of investors is that they take care of their weeds (their investments that have done poorly) while pulling out their flowers (selling their investments in companies that are performing well). Let’s delve a bit deeper into this practice to understand the rationale behind it, and what can be done to alter such damaging behaviour.
Watering the weeds
Taking care of an investment portfolio is akin to managing a garden full of saplings and plants. In gardening parlance, many investors choose to “water the weeds” by continually devoting time, effort, and resources to the companies in their garden which are performing poorly. These companies may have started out with good promise and stellar performances. But over time, they have fallen by the wayside with declining revenue, profits, and dividends because of management missteps, poor capital allocation, or stiffer competition.
Many investors remain stubborn and refuse to let such companies go, even though they act as deadwood within their portfolios. Reasons for this behaviour include the sunk cost fallacy (money is already sunk in, therefore making the investor believe that he needs to commit further time and resources), loss aversion, and also the anchoring bias.
Pulling out the flowers
As if watering the weeds isn’t a bad enough practice, some investors exacerbate the problem by constantly selling shares in companies which register good performances. This arises from the action bias as well as a need to “take profit” for fear that any gains may vaporize. By selling a profitable position, we can avoid regret while also boosting our pride and ego.
The share price of a company rises over time due to a combination of business growth and an increase in dividends paid. By selling shares of good companies, we are therefore missing out on many years of future compounding, which would severely and negatively impact our wealth-building journey.
The Foolish Bottom Line
As investors, we should learn to water our flowers and pull out our weeds instead. We should optimize our portfolios by constantly getting rid of poorly-performing investments (yes, even at a loss!) and re-allocating the capital to more promising ideas. For companies that are performing well, we should “water” them by devoting time and possibly even more capital to them so as to be able to compound our wealth successfully over time.
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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice.