Koon Yew Yin 官有缘 - Koon’s Investment Lesson #5: Loss Aversion

Statistics show that most equity investors including professionals cannot beat the stock index. Studies have also shown that more than 80 % of day traders lose money mainly due to transaction costs and they select shares based on hot tips. There are several reasons for their poor performance but the most frequent mistake is ‘loss aversion’. This is a psychological obstacle which has been consistently affecting their performance especially in view of the frequent share price fluctuation that is the normal behavior of the stock market.

My Share Selection Golden Rule

It is easy to master the basic fundamentals of share selection. There are a few selection criteria such as NTA, discounted cash flow, return of equity, EPS etc. The most powerful catalyst for moving share price is EPS growth. After many years of trial and error, I have formulated my share selection golden rule. I must be sure the company can make more profit in the current year than last year by looking at the last few quarterly result before I buy the share and it is selling below P/E 10.

Do not buy on rumors and hot tips.

There is a classical saying for the stock market ‘you can still buy the winning horse after the race’. In the real horse racing, you cannot buy the winning horse after the race. But in the stock market, you can. It means that you can still buy the share after the company has announced good profit growth result and the share is selling below 10 P/E.

After you have bought some stocks based on my golden rule, you will have to decide when and which stock to sell. Often many investors make the mistake of selling the good ones to lock in profit early but retain those that are not performing because of their aversion to taking losses on these. Some regret their action later and may buy back the same stock at a higher price. Most of them do not jump back to buy the stock and they can only watch the stock going higher and higher.

Loss Aversion:

Some investors may object to the implication that loss aversion is a bad thing. After all, it is a very natural behavior. They might justifiably point out that the tendency to weigh losses more heavily than gains is a net positive attitude. After all, investors who care too much about possible gains and too little about potential losses, run a great risk that can threaten their portfolios. It may appear better to care more about the share price falling than hoping for it to climb higher.

True enough; loss aversion can be helpful and is part of a conservative strategy. But an over sensitivity to loss can also have negative consequences. One of the most obvious and most important areas in which loss aversion skews judgment is in selling too early and missing the additional profit if you dare to hold it longer. Very often even clever investors who are well versed in stock selection cannot overcome this psychological fear.

What is tricky about this concept of loss aversion is that it can often lead us in the opposite direction- to hold on to a losing investment for longer than we should. I asked one of my friends why he sold a particular stock instead of selling his other holdings that he bought at higher prices? He said that he did not want to recognize the losses but preferred to lock in the profit. This is the most common mistake committed by investors because they do not want to admit their mistake of picking the wrong stock. Moreover, the profit from the sale could easily cover the losses.

Studies have shown that on average, it is easier for well managed companies to continue their good performance than for bad companies to improve their poor position. That is why we should not sell good shares too early and retain the bad shares.

When to sell?

This is the most tricky part of the game in making money. After having said all that about selling too early due to the loss aversion phenomenon, we must not forget that no share can keep climbing up and up indefinitely for whatever reasons. In other words, we must not be too greedy and wait for the bubble to burst. Hence the time to sell is when the reasons why you bought the share – undervalued, good profit growth prospect and it complied to my golden rule, are no longer there or valid. Sometimes you have to sell to raise cash to buy another stock which is better.

Koon Yew Yin 官有缘 - Koon’s Investment Lesson #5: Loss Aversion