Here's a little quiz: You have to choose between: (a) winning Rs 85 thousand outright; or (b) an 85% chance of winning Rs 100 thousand. Chances are you'd choose (a). After all, a bird in hand is worth two in the bush.
Now let's change the story while keeping the numbers identical. Now you have a choice between: (a) losing Rs 85 thousand outright or; (b) an 85% chance of losing Rs 100 thousand. Chances are you'd take choice (b) because you have a 15% possibility of losing nothing.
Loss Aversion
Clearly, there is no logical reason for anyone to prefer one option over another; all have identical expected values. But people don't think like that. They behave irrationally by weighing prospective losses heavily as compared to prospective gains. Psychologists call this as the concept of "loss aversion."
Another example: If an investor owns two stocks, both of which are currently quoted at Rs 20, but one of which he bought at Rs10 and the other at Rs 25, he might not sell the latter one (even if its price was falling) because he did not want to suffer a loss. If he thought about the combined value of the two shares, however, he might be happy to sell both, as that would produce a net gain.
Irrationality in Sell/Retention Decisions
The decision whether to sell a security or to hold on to it involves the maximum irrationality. For example, many individual investors as well as institutions, when in need of money, would sell only those investments in which they have unrealised gains even though selling those in which they have unrealised losses would be a far better alternative. Short-term accounting results are often preferred at the cost of long-term economic results. Peter Lynch, a very successful mutual fund manager, likens such behaviour to "cutting the flowers and watering the weeds."
Another example of irrationality in the sale/retention decisions can be described by the following conversation between an investment advisor and a client:
Advisor: "I would recommend that you should sell your shares in company X. The stock is selling for Rs 200 but its overpriced and is really worth only Rs 100 or so."
Client: "I agree its a lousy stock. I bought it for Rs 600 per share, and now it's selling for only Rs 200 per share. But if I sell it now, I'll lose a lot of money."
Advisor:: "You have already lost the money."
Client: "No, I haven't. It's just a paper loss."
Original Cost is Immaterial
In the above conversation, although the investor is willing to admit that he made a mistake by buying an overpriced stock in the first place, he is making another mistake by thinking of the original cost in his sell/retain decision. The second mistake arises from his misunderstanding about the timing of loss that arises out of a bad investment.
If anyone bought shares in ACC for Rs 10,000 each in 1992 or in Real Value Appliances for Rs 100 in 1995 or in MS Shoes for Rs 500 in 1995 or in Reliance Industries for Rs 400 in 1994, then he lost his money at the time of the investment, not at the time of the sale of the shares. This is true even though standard accounting principles as well as tax laws would allow him to recognise a loss only at the time of sale.
One of the fundamental rules of intelligent investing is that one should be quick to cut ones losses. Everyone makes mistakes. Even great investors like Warren Buffett, John Templeton and Peter Lynch have acknowledged having made mistakes. But their greatness comes from their ability to recognise these mistakes and then to take corrective action.
The important thing to remember is that ignoring tax consequences, the decision to sell a security has nothing to do with the cost of the security. Only two things matter - price and value. If a stock is overpriced it should be sold. Period. The original cost of the stock is immaterial. In fact, even if a stock is under-priced, it should still be sold if a far better alternative becomes available.
A great investor like Templeton would not hesitate in selling a stock that he bought for x which in his opinion is worth 2x, if a better alternative - say a stock worth 4x becomes available at a price of x. He would do it, even if he would have to sell the original stock at 0.75x and suffer an accounting loss of 0.25 x.
Switching Operations in a Bear Market
Bear markets, sometimes, offer great opportunities to investors to switch from their lousy stocks into great stocks selling at bargain prices. Most people, however, fail to take advantage of such opportunities. They get paralysed by constantly looking at the unrealised losses in their portfolios.
For example, assume that an investor owns shares in a lousy company A that he bought for Rs 300, but which are now selling for Rs 200. The investor knows, he's made a mistake but he finds it impossible to sell at a loss. He is waiting for the price to go up to Rs 300 when he would sell. Assume further that the investor knows of a great company B whose shares are selling at a bargain price of Rs 200 per share but are actually worth at least Rs 600 per share. The rational decision for this investor would be to sell shares in A and buy equal number of shares in B. But chances are that he will wait for shares in A to go up to Rs 300 before he sells them. But it is also likely that when shares in lousy company A go up to Rs 300, shares in great company B may have zoomed to Rs 600. Earlier, the cash raised from sale of A would have bought equal number of shares in B. Now, that cash would buy only half as much. The investor's irrational behaviour has cost him real money.
A Psychological Difficulty
Of course, saying it here that one must ignore original cost in taking a sell or retain decision is easy. Doing it in real life is very, very difficult. Peter Lynch, once explained the problem in these words:
"Many people suffer from a syndrome called "when-it-rebounds-to-$10, I'll-sell." In my experience no downtrodden stock ever returns to the level at which you've decided you'd sell. In fact the minute you say, "If it gets back to $10, I'll sell," you've probably doomed the stock to several years of teetering around just below $9.75 before it keels over to $4, on its way to falling flat at $1. This whole painful process may take a decade, and all the while you're tolerating an investment you don't even like, and only because some inner voice tells you to get $10 for it."
Difficult though the task may be, it is imperative that intelligent investors ignore original cost in their sell/retention decisions except when there are important tax consequences.
A Practical Solution
One great investor, Philip Carret, offered a practical solution to the problem, back in 1930, which remains valid to this day. He wrote: "The investor should seek so far as possible to reanalyse each commitment from a detached standpoint. Psychologically this is a very difficult thing to do, to consider dispassionately a venture in which he risked his funds. Nevertheless, the investor should make a determined effort to do just this. If he has 100 shares of a given stock, for example, which is selling at 90, he should disregard entirely the price that he paid for it and ask himself this question: "If I had $9,000 cash today with which to purchase some security, would I choose that stock in preference to every one of the thousands of other securities available to me?" If the answer is strongly in the negative, he should sell the stock. It should make not the slightest difference in this connection whether the stock cost 50 or 130. That is a fact that is entirely besides the point, though the average individual will give it considerable weight."
A Suggested Procedure
Here is a suggested procedure that an intelligent investor should follow whenever he is contemplating selling any of the shares in his portfolio (ignoring tax considerations):
Freedom from Past Decisions
Ben Graham once said, "the investor's worst enemy is likely to be himself." The inability of most investors to ignore historical cost while taking sell/hold decisions is a common example justifying Ben's thoughtful comment.
Note
This article is submitted by Sanjay Bakshi who is the Chief Executive Officer of a New Delhi based company called Corporate Investment Research Private Limited.
© Sanjay Bakshi. 1996.