It is hard for us to admit we’ve made a bad investment, and it is
even harder for us to admit that mistake to others. But to be a successful
investor, you have no choice but to do so. Decisions on your portfolio
must be made on a forward-looking basis. What has happened in the past
cannot be changed. It is a “sunk cost,” as economists say. When
prospects don’t look good, sell the stock whether or not you have a loss.
Dave:I thought the stocks were cheap when I bought more shares.
Many were down 50 percent or more from their highs.
IC:Cheap relative to what? Cheap relative to their past price or their fu-
ture prospects? You thought that a price of 40 for a stock that had been
80 made the stock cheap, yet you never considered the possibility that 40
was still too high. This demonstrates another one of Kahneman and
Tversky’s behavioral findings: anchoring, or the tendency of people fac-
ing complex decisions to use an “anchor” or a suggested number to form
their judgment.^22 Figuring out the “correct” stock price is such a complex
task that it is natural to use the recently remembered stock price as an
anchor and then judge the current price a bargain.
Dave:If I follow your advice and sell my losers whenever prospects are
dim, I’m going to register a lot more losses on my trades.
IC:Good! Most investors do exactly the opposite and realize poor re-
turns. Research has shown that investors sell stocks for a gain 50 percent
more frequently than they sell stocks for a loss.^23 This means that stocks
that are above their purchase price are 50 percent more likely to be sold
than stocks that show a loss. Traders do this even though it is a horrible
strategy from a tax standpoint.
Let me tell you of one short-term trader I successfully counseled.
He showed me that 80 percent of his trades made money, but he was
down overall since he had lost so much money on his losing trades that
they drowned out his winners.
After I counseled him, he became a successful trader. Now he says
that only one-third of his trades make money, but overall he’s way
ahead. When things don’t work out as he planned, he gets rid of losing
trades quickly while holding on to his winners. There is an old adage on
Wall Street that sums up successful trading: “Cut your losers short and
let your winners ride.”
330 PART 4 Stock Fluctuations in the Short Run
(^22) Amos Tversky and Daniel Kahneman, “Judgment under Uncertainty: Heuristics and Biases,” Sci-
ence, vol. 185 (1974), pp. 1124–1131.
(^23) Terrance Odean, “Are Investors Reluctant to Realize Their Losses,” Journal of Finance, vol. 53, no.
5 (October 1998), p. 1786.