Why we hold on to our dud shares

So ingrained is the tendency to not sell losing shares that
investors and traders are known to have been ruined by this phenomenon.

Time and again fund managers are known to have come to grief for the same reason. Companies are known to have kept bad news from the market and investors for far too long hoping to recover ground, only to come to grief.

The reason why we don’t sell a falling stock sooner is more or less the same as why we don’t throw out that pinching shoe in a hurry or why we typically prevaricate about cleaning of accumulated junk in our homes — namely the ‘status quo’ bias — of which we spoke in this column two weeks ago.
But that is not all. There are other reasons as well. Our mind plays some tricks of its own.

Assume that you bought a stock at Rs200, and that its price has now fallen to Rs140 following sustained bad news. You are reluctant to sell because doing so makes the loss of Rs60 ‘real’, while prevarication, in the hope of recovery, keeps the loss ‘notional’.

A notional loss is easier to live with than a real loss, because it
appears as if you can make good your loss. So why convert the
notional loss into a real one by selling? So you hang on.

Now let’s say the price drops to Rs100. The same logic holds,
except that converting the notional loss into a real one looks even more unpalatable to most people. As the price keeps tumbling, it gets increasingly difficult for us to
accept the real loss, making it more and more difficult to give up the paradise of the notional loss, until it is too late!
That’s not all. We tend to take losses more badly than we take gains well. We aren’t as happy at finding a Rs500 note as we are depressed at the loss of an equal sum  from the wallet. This is called loss aversion.

Loss aversion is the reason we normally do not accept an even-bet that has a 50% probability of winning or losing Rs50.

Also, we are more averse to an even-bet of winning or losing Rs100; and even more averse to an even bet of winning Rs500 and losing Rs500 and so on (within our actual wealth level).
When it comes to our shares and stocks, as a stock price keeps
tumbling, we keep postponing our acceptance of the bad news.

Till it is too late
There is yet another aspect of human nature at play here. Consider our behaviour during arguments with friends or rivals.  None of us likes losing one. The best time to quit an argument is when we realise we may be losing it; that’s when the loss of face is minimal. But since we dislike any loss of face, we hang on to the argument, hoping to claw back some ground. As we begin to slip some more, we cling harder to our losing arguments because by now the loss of face has become larger than life and the stakes for quitting have become higher. It’s the same with stocks.

We hate losing money on declining stocks. It would be best to quit early as soon as we realise that the stock was a bad pick to begin with. But fearing the loss, we cling on a little longer, and then it gets even harder to quit and so we cling on even more.

Somehow, it also turns into a matter of ego — a matter of pride and honour to recover our money from that very stock!

A more reasonable approach would have been to cut the losses at the first realisation that a stock is no good or of doubtful quality, and invest the proceeds in another stock that one believes may rise faster rather than wait for the dud to recover.

For example, if you bought a stock at Rs200 and soon thereafter realise that that there is something quite wrong with that company, and the stock is already down, it is best to sell off the stock and invest in another that you believe is fundamentally good.

Clearly, if this is a good stock, your new stock, bought for a lower sum, may appreciate much faster than the dud. But then we are all victims of our nature and it takes a bit of thinking from the head rather than the heart to do so.