1 May 2018

Weeding out the losers

Last week we finally had some sunshine and the first glimpse of spring.

With the change in weather gardeners will have been able to get out and tend to their gardens that haven’t seen much attention over the wet winter months. This brings to mind the gardening analogy that is often used by investment managers to describe their approach to portfolio management. Pulling up weeds and letting your flowers bloom is a helpful description for cutting one’s losses and running your winners, but is it as easy when managing an actual investment portfolio rather than a flowerbed?

Professional and retail investors alike struggle with selling investments that have fallen in value. Partly because it can be difficult to admit we were wrong; but it is also because we do not always behave rationally. The psychologists Daniel Kahnemann and Amos Taversky tackled this in their Prospect Theory in 1979, in which they showed that humans are instinctively loss averse, and therefore we weigh losses greater than gains. A simple monetary example is to consider the difference between finding a £10 note to finding two £10 notes and then losing one. The end result is the same as we have £10 in our pocket, but emotionally we view the first situation more favourably than the second.

Kahnemann and Taversky’s findings greatly impacted the world of economics. Richard Thaler, who collaborated with them, expanded their theory into economics and identified the Endowment Effect: that as humans are loss averse, we put greater store on things that we own. For example, if you found a valuable bottle of wine in the attic, you may well refuse to sell it for hundreds of pounds, even though you would not dream of paying the same amount to buy the bottle.

These Nobel Prize-winning theories have shown that we behave irrationally with regards to assets that we own, and that we are hardwired to avoid losses. It is therefore important to be aware of this when investing. As an investor may feel justified for holding on to a losing stock for a long time once it has recovered, they should consider the opportunity cost of doing so and that they may have recovered their losses more quickly in another investment. That some people will hold a stock for years waiting for a recovery, simply to sell it once it no longer stands at a loss, illustrates that rational analysis of the investment case can easily be replaced by an irrational desire to avoid realising a loss.

Yet, it is a natural function of markets that they move upwards and downwards. One should not sell a stock simply because it has fallen, just as one should not buy a stock simply because it is rising. As a long-term investor I am happy to hold shares as they ride the natural waves of the investment cycle. But it is also important to stay focused on fundamentals, judging each investment on its merits and try to recognise if and when the investment case has changed.

So the gardening analogy is a good one to remember when trying to overcome our natural instincts to behave irrationally towards our investments. And while we should be sure that a weed we are about to remove is not in fact a flower, we should remember that only by removing the weeds from our portfolio will we allow it to blossom.

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