Losing money is painful but for investors, the bigger danger can be what happens after the loss.

In this episode of Investing Compass, Mark LaMonica and Shani Jayamanne explore the behavioural biases that can cause investors to make two very different mistakes: selling investments that are still performing well because they’re afraid of giving back their gains, and holding onto losing investments because selling would mean admitting the loss.

Mark and Shani explains why the price you paid for an investment shouldn’t determine what you do with it today and why asking “Would I buy this investment at its current price?” can be a useful way to cut through the emotion.

The conversation also looks at the Concorde fallacy, loss aversion, Warren Buffett’s costly experience with Tesco and how investors can create rules in advance to stop emotions taking over when markets move against them.

You can find the full article here.

Shani has also done a wrap up on the best behavioural finance insights from Morningstar here.

Other behavioural insights:

Does money buy happiness? Yes - and it’s crucial to properly defining your goals.

Why too much choice is making you a worse investor Are you a maximiser or a satisficer?

Do you know why you are investing? Research from our Behavioural Insights team suggests that many investors should clarify what drives their investment decisions.

Future Focus: Market returns are secondary to this return driver Want to be a successful investor? You’re focusing on the wrong thing.

Are you an emotional investor? Ever wondered how you can make better financial decisions?

You can find the transcript below:

Mark LaMonica: Welcome to another episode of Investing Compass. Before I begin, a quick note that the information contained in this podcast is general in nature, which is not taken into consideration personal situation, circumstances, or needs. We have two important announcements today, Shani.

The first one is a repeat. We do have an upcoming one-year anniversary show for the book, Invest Your Way, available in bookstores. And we would love it if people could send in questions. So we’re going to do a QA type episode where we answer people’s questions.

You can send those into my email address, which is in the show notes. The other important announcement is your campaign to paint me as some sort of turtle aficionado. Has worked.

Shani Jayamanne: Has worked.

LaMonica: Has worked. I received a Instagram message from a listener with a video of a turtle.

Jayamanne: Barnacle removal on a turtle. So they got the genre right. But we actually, so in the YouTube version of the podcast, Will actually put in some bloopers at the end, which we had no idea going in, so that was fun.

LaMonica: Which was very entertaining. Will did a great job on that.

Jayamanne: Yes.

LaMonica: Let’s get into the episode. We’ve covered the book episode and turtle news. So what are we going to talk about?

Jayamanne: There’s nothing left to talk about.

LaMonica: So I’m just listening.

Jayamanne: Yeah. So today we’re going to do an episode that is based on two very different mistakes that investors can make. And that’s based on the fear of losing money. But before we do dive in, we’re going to speak a little bit about airplanes.

LaMonica: We are. We’re going to speak about a specific airplane, the Concorde and the Concorde.

Jayamanne: Yeah. Is that how the US pronounced it?

LaMonica: No, the Concorde. Okay. And according to you, you wrote an article and you called the Concorde the greatest technological achievement of the 20th century.

Jayamanne: No, I said one of.

LaMonica: So I think it’s pushing it a little bit. But for people who don’t know, it’s a supersonic passenger aircraft. It could fly between London and New York in around three and a half hours. And of course, for comparison, in 2026, it takes around seven and a half to eight and a half hours to do that. And that is westbound and then eastbound, six and a half to seven and a half hours. So it reduced flight time by half, which is why you think it’s so great.

Jayamanne: Yes. And Britain and France poured an obscene amount of money into the project and into developing it. And despite it being an engineering success, the economics weren’t very impressive. Development costs escalated to more than ten times the original estimates. It guggled fuel. It had expensive maintenance, and because sonic booms were really loud, it limited where it could actually fly because the commercial viability wasn’t really there because the sonic booms were very loud.

LaMonica: And then it crashed. There was a crash in the year 2000. That led to issues. I think the whole fleet was grounded for a while, and it eventually returned to service in 2003. And I think the interesting point that you were trying to make in this article is even after it was obvious that this thing was not going to be commercially viable, the UK and France kept investing in it.

Jayamanne: So why are we talking about the Concorde? It’s because it became a very famous example of something called the sunk cost fallacy. And that’s allowing money or time that has already been spent to influence what you’re going to do in the future and whether you continue to invest in a project. By the time it was clear the economics would never really justify the development bill, the billions already invested were unrecoverable.

LaMonica: And you know, we know rationally that shouldn’t have been a deciding factor in future decisions, how much you’ve sunk in. But the Concorde was such a good example that the sunk cost fallacy became known as the Concorde fallacy.

Jayamanne: Or the Concorde fallacy.

LaMonica: Yeah, that too. If you would like to pronounce things, why don’t you tell people how you say sponge?

Jayamanne: I’m good.

LaMonica: Okay, refusing to do that. So the reason, of course, Shani brought this up, the reason we’re talking about sunk cost fallacy is because investors often face this same dilemma. So that’s of course the tie-in to this episode.

Jayamanne: Yeah So for example, if I’m an investor who owns a $10,000 investment today that I bought for $20,000, the $10,000 loss is not a reason to keep holding it. That loss has already happened. The decision I have to make is what to do with the $10,000 that I left.

LaMonica: The question that matters in this scenario is would you rather keep that money invested where it is, or is there someplace better to put it? And that leads into why we are so likely to get ourselves in a position where we need to ask these questions, and that’s because of loss aversion. So loss aversion is the concept that we don’t treat gains and losses symmetrically. So research from the two founding members of behavioral finance, Amos Tversky and Daniel Kahneman showed that losses feel about twice as painful as an equivalent gain feels good. And in a Morningstar study, 65% of respondents showed signs of being more impacted by losses than equivalent gains.

Jayamanne: And what is difficult about loss aversion is that there is no straightforward answer to avoiding it. You’re going to feel the loss more than you feel gains. What’s important is that you are aware of the natural tendency that we have, and that could help you make better decisions.

LaMonica: So let’s talk about how this often plays out in investor portfolios. So the first thing that happens is investors tend to sell the winner. So an investment that you own has gone up. You’ve made those paper gains, but then the price starts to fall.

And suddenly that gain that you were enjoying is disappearing right before your eyes. So you might have bought the share at $20, watched it climb to $40, then it falls to $35. You still haven’t lost money. You’re still sitting on that $15 gain.

Jayamanne: And psychologically, that experience can also feel like a loss. The $40 becomes your new reference point for your investment, and you’re watching the investment fall from there and it feels painful. That can lead to you selling at $35 just because you’re worried that the next move will take you to $30, $25, or even $20.

LaMonica: And this is just another example of decision making that’s influenced by factors other than the specific investment’s future prospects. So you’re really basing what to do with this investment on the desire to avoid experiencing a future loss. The price that you’re paying for this is, of course, the potential upside as well as the tax and transaction cost that you’ll have to pay if you sell.

Jayamanne: And this is where having a decision making framework like an investment policy statement or an IPS comes in really useful and it becomes important. If I become if I buy an investment because I believe it has long-term potential, I don’t want to sell and I don’t want that decision to be influenced by how uncomfortable I feel when the price moves against me. I want to know in advance what would make me change my mind.

LaMonica: Now, assuming you’ve gone through the trouble setting up this IPS, let’s look at some reasons why you would actually sell, why it would be a good reason to sell. So one is that your investment thesis has changed. So that means basically you no longer believe in the future prospects of this investment. Another is valuations could have become unreasonable, or the fundamentals of the investment have changed and it doesn’t align with what you’re trying to achieve in your portfolio.

Jayamanne: Okay, so let’s move on to the second biggest mistake that’s motivated by avoiding losses, and that’s being an investor who refuses to sell the loser. So in this scenario, you’ve bought an investment for $20 and it falls to $10. You don’t want to sell because doing so would make the loss real. As long as you continue to hold it, there’s still this possibility that it will go back to $20, and that’s where the price you paid becomes an anchor.

LaMonica: Yeah, and I’ll talk a little bit about this because I know you’ve never bought an investment that has gone down. But for me, and for anyone listening who has experienced this, you should know that you’re in good company. So Warren Buffett admitted to this being something that has impacted him. So specifically, his 2014 letter to Berkshire shareholders, Buffett talked about an investment in Tesco. So Berkshire eventually sold the position for an after-tax loss of US$444 million.

Jayamanne: And Buffett admitted that the company had been slow to act in this case. He described the delay as in selling as thumb sucking and basically that waiting had made the eventual loss worse.

LaMonica: Yes, and thumbsucking after a certain age is not great.

Jayamanne: Or at any age.

LaMonica: Or at any age. So the message to investors is that when you’re evaluating an investment and you’re trying to figure out what the future prospects for that investment are, ignore or try to ignore the price that you actually paid for it. And it is worth asking the question knowing what you know today, would you buy that investment that’s in your portfolio at its current price? And if the answer is no, the fact that you once paid more for it shouldn’t be a deciding factor.

Jayamanne: And this is related to what behavioral economists call the disposition effect, and that is the tendency to sell investments that have risen while holding on to investments that have fallen. It is a Concorde story all over again. And being a successful investor doesn’t mean avoiding every bad investment. It means being able to recognize when an investment has worked and redirect capital towards a better opportunity.

LaMonica: All right, let’s go through some tips. And these are tips to minimize the impact, a loss aversion and setting up the rate systems and framework so that you can stop or at least lower the impact that emotions have on your decision making. All right, the first is honest portfolio reviews. And going through a portfolio review is a good time, of course, to be honest with yourself. Look at your holdings and ask whether each still deserves a place in your portfolio. And specifically ask if it still aligns to your investment strategy.

Jayamanne: And there could also be a tax benefit to realizing a genuine capital loss. Capital losses can generally be used to offset capital gains. If your capital losses exceed your gains, the net capital loss can be carried forward to offset future capital gains. We’re not telling you to sell an investment purely to create a tax loss. Tax should be one consideration, not the entire investment thesis. If you’ve already made up your mind that an investment doesn’t belong in your portfolio, there’s not much reason to let loss aversion stop you from making that decision.

LaMonica: And our second tip is to define your selling criteria and actually put that into your investment policy statement or IPS. And this really helps with that other side of loss aversion. Selling an investment too early because you don’t want to give back a paper gain. So the best thing to do is establish what would make you sell before you start investing.

So just set those rules. Could be one of the reasons we spoke about. So a change in the investment thesis, a valuation threshold that it’s crossed, a portfolio allocation limit, or some sort of specific fundamental change to that investment.

Jayamanne: And the key is really avoiding uh making up the rules as you go. If you decide what would make you sell ahead of time, you’re much less likely to make a poor decision when you are staring at a falling share price or market and feeling anxious.

LaMonica: Our final tip is using rebalancing to take some of the emotion out of that process. So rebalancing gives you a systematic way to manage your gains and losses. So if an allocation in your portfolio has grown beyond what you intended, you can trim it and then redirect the money towards areas that have fallen below their target allocation. The good thing about this is it doesn’t require you to predict which asset will perform better in the future. It just forces you to follow this predetermined framework.

Jayamanne: So to wrap up, it’s worth just acknowledging that you’re going to lose money on some investments. It’s inevitable as a long-term investor. You’ll buy shares and ETFs that fall in price, and you don’t buy these investments because you’re not sure about them. You buy them because you’re confident about their future prospects.

LaMonica: And the danger that we’ve been trying to talk about today is letting your emotions influence what you do next. You don’t want loss aversion to hinder your outcomes, to sell investments that still have a strong future ahead of them, and then hold investments that don’t. So create enough structure around your decision making to minimize your emotions and any damage that they can have that they can have on your portfolio outcomes.

Thank you very much for listening. Thank you for your patience with my pronouncement of Concorde, and thank you in advance for sending in those questions to our episode to celebrate the one-year anniversary of our book.

(Disclaimer: Any advice in this podcast is general advice or regulated financial advice under New Zealand law prepared by Morningstar Australasia proprietary limited and/or Morningstar Research Limited without reference to your financial objectives, situations or needs. You should consider the advice in light of these matters and any relevant product disclosure statement before making any decision to invest. To obtain advice for your own situation, contact the financial advisor.)

Invest Your Way

A message from Mark and Shani

For the past five years, we’ve released a weekly podcast and written on morningstar.com.au to arm you with the tools to invest successfully. We’ve always strived to provide independent, thoughtful analysis, backed by the work of hundreds of researchers and professionals at Morningstar.

We’ve shared our journeys with you, and you’ve shared back. We’ve listened to what you’re after and created a companion for your investing journey – Invest Your Way. Invest Your Way is a book that focuses on the investor, instead of the investments. It is a guide to successful investing, with actionable insights and practical applications.

If anyone would like to support this project you can buy the book now. Thanks in advance!

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