Future Focus: You’re losing money twice. Here’s how to stop.
The fear of losing money can lead investors to make two very different mistakes. Here’s how I try to make sure it doesn’t influence my investment decisions.
The Concorde was one of the great technological achievements of the 20th century. The supersonic passenger aircraft could fly between London and New York in around three and a half hours. Britain and France poured enormous amounts of money into developing it.
Despite its engineering success, the economics were far less impressive. Development costs escalated to more than ten times the original estimates, while high fuel consumption, expensive maintenance and restrictions on overland supersonic flight due to sonic booms limited its commercial viability.
The fatal Air France Concorde crash in 2000 further weakened passenger demand, although the aircraft returned to service before its eventual retirement in 2003. The British and French governments continued to fund the project even after realising it would be close to impossible to turn a profit.
The project became a famous illustration of the sunk cost fallacy - allowing money already spent to influence whether you continue investing in a project. By the time it was clear the economics would never justify the development bill, the billions already invested were unrecoverable. However, that shouldn’t have been the deciding factor in future decisions. It became so much of an example that sunk cost fallacy gained another name – the Concorde Fallacy.
Investors often face the same dilemma as the British and French government who sunk money into developing the Concorde. An example is illustrative.
If I own 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 I have left.
Would I rather have it invested in this asset, or would I rather put it somewhere else? That is the question that matters.
Loss aversion
We don’t treat gains and losses symmetrically. Research from Amos Tversky and Daniel Kahneman showed that losses feel about twice as painful as an equivalent gain feels good. In one Morningstar study, 65% of respondents showed signs of being more impacted by losses than equivalent gains.
For investors, this can create a particularly frustrating problem. Trying to apply the lessons from loss aversion doesn’t tell you what to do. But awareness of this natural tendency could improve your decision making.
I’ve outlined several lessons investors can apply when considering how to approach this dilemma.
The investor who sells the winner
The first scenario is owning an investment that has gone up. You’ve made paper gains but then the price starts to fall. Suddenly the gain you were enjoying is disappearing before your eyes.
You might have bought a share for $20 and watched it climb to $40. It then falls to $35. You haven’t lost money – you’re still sitting on a $15 gain.
Psychologically, the experience can feel like a loss. The $40 becomes your new reference point, and watching the investment fall from there feels painful. That can lead to an investor selling at $35 simply because they are worried that the next move will take them to $30, $25 or even $20.
This is an example of decision making that is influenced by factors other than the investment’s future prospects. It is based on the desire to avoid experiencing a future loss. The price paid is the potential future upside as well as tax and transaction consequences.
This is where having a decision-making framework like an Investment Policy Statement (IPS) becomes particularly important.
If I buy an investment because I believe in its long-term potential, I don’t want my sell 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.
Legitimate reasons for sale that may align with your IPS may be:
- The investment thesis has changed and you no longer believe in the future prospects of the investment
- Valuations have become unreasonable
- The fundamentals of the investment have changed and it does not align with what you are trying to achieve in your portfolio.
The investor who refuses to sell the loser
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 is still the possibility that it will get back to $20. This is where the price you paid becomes an anchor.
The investment’s future prospects aren’t influenced by the price you paid. It’s worth asking the question - knowing what you know today, would you buy the investment at its current price? If the answer is no, the fact that you once paid more for it shouldn’t be the deciding factor.
This is related to what behavioural economists call the disposition effect: the tendency to sell investments that have risen while holding onto investments that have fallen. It is the Concorde story all over again.
Buffett’s brush with loss aversion
Even Warren Buffett has made mistakes. In his 2014 letter to Berkshire Hathaway shareholders, Buffett discussed the company’s investment in Tesco. Berkshire eventually sold the position for an after-tax loss of about US$444 million.
What makes the story particularly useful is that Buffett admitted the company had been slow to act. He described the delay in selling as ‘thumb-sucking’ and acknowledged that it had made the eventual loss worse.
Being a successful investor doesn’t mean avoiding every bad investment. It means being able to recognise when an investment hasn’t worked and redirect capital towards a better opportunity.
Minimise the impact of loss aversion
Set up the right systems to stop your emotions making decisions for you.
1. Honest portfolio reviews
Your portfolio review in the middle of the year is a good time to be honest with yourself. Look through your holdings and ask yourself whether each one still deserves a place in your portfolio. Ask whether it still fits your investment strategy.
There may also be a tax benefit to realising 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 indefinitely to offset future capital gains.
That doesn’t mean you should sell an investment purely to create a tax loss. Tax should be one consideration, not the entire investment thesis. If you have already concluded that an investment no longer belongs in your portfolio, there is little reason to let loss aversion stop you from making the decision.
2. Decide your selling rules in your Investment Policy Statement (IPS)
The other side of loss aversion is selling an investment too early because you are frightened of giving back a gain.
Before investing, establish what would make you sell. It could be one of the reasons I mentioned before - a change to the investment thesis, a valuation threshold, a portfolio allocation limit or a specific fundamental change.
The key is avoiding making up the rules as you go. If you decide what would make you sell ahead of time, you are much less likely to make a poor decision when you are staring at a falling share price or market and feeling anxious.
3. Use rebalancing to take some emotion out of the process
Rebalancing can also provide a structural way of managing gains and losses. If an allocation in your portfolio has grown beyond what you intended, you can trim it and redirect the money towards areas that have fallen below their target allocation.
This doesn’t require you to predict which asset will perform best next but forces you to follow a pre-determined framework.
Final thoughts
You are going to lose money on some investments. It is an inevitable as an investor.
You will buy shares and ETFs that fall in price. Often these are investments you purchased feeling confident about their future prospects.
The danger is allowing the emotional discomfort of a loss influence what happens next. Sometimes loss aversion causes you to sell an investment that still has a strong future while holding investments that don’t - this is the situation you want to avoid.
Create enough structure around your decisions to minimise emotions hindering your outcomes.
Invest Your Way
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