Do you own stocks that are down significantly since you bought them, but can’t bring yourself to sell?
Selling “loser” stocks can make sense, especially as we get close to the year’s end and those losses can offer a tax break on capital gains elsewhere in one’s portfolio. Yet, investors tend to do just the opposite: they sell portfolio winners and hang onto losers. That’s the consistent finding of nearly thirty years of research on the disposition effect, beginning with a 1985 paper by Hersh Shefrin and Meir Statman.
The disposition effect is a behavioral anomaly consistent with Prospect Theory, which suggests that the pain of losing a certain amount of money is greater than the pleasure of earning the same amount. And investors don’t consider their gain or loss “real” until they sell.
Maury McCoy, a financial consultant, has experienced the disposition effect and learned his lesson. “After a number of years of investing, one of the lessons I’ve learned is it is okay to take a loss and move on,” he says. “I’ve held three stocks to zero, which is a painful experience.”
So what the “biggest losers” in investors’ portfolios these days? According to data from our users – investors who sync their portfolios with SigFig, in third place is a once-hot tech startup whose performance fizzled fast and furious after a hyped-up IPO. Investors who own this stock – Zynga (ZNGA) – have, on average, a 30% unrealized loss (as of Oct 13, 2014). And the top two are, well, Growlife (PHOT), a “cultivation services provider,” and Medical Marijuana Inc (MJNA): two marijuana stocks that are far off their one-time highs.
So why are folks holding onto these stocks?
Some cop to the disposition effect, admitting that they don’t want to sell at a loss. Nathan Polak, a business analyst and MBA candidate, owns MJNA. “My logic was that as these and other markets opened to the marijuana industry, the stock would appreciate due to increased revenues,” he says. “I believe the term at the time was ‘Pot Fever,’ and I foolishly failed to do thorough research on this company.”
Now, he says he’s holding the stock “mainly to just see what happens.”
But some investors truly believe in the potential of a stock to recover. McCoy, who had experienced the pain of holding stocks that become worthless, now owns ZNGA — because he thinks the stock is worth more than its current price. “I see this stock as an option on Zynga potentially having a big winner in the mobile gaming or real money gaming space,” he says.
Christopher Soria, a retail banker, says he bought MJNA and PHOT because he believes “marijuana legalization is inevitable in the U.S. and this stock will benefit from it (or at least the hype).” He plans to sell if the federal government blocks the possibility of legalization definitively, but his current plan is to hold the shares until “something hypes them up, then sell on the hyperbolic rise, and buy back sometime later.”
Hold on or cut loose?
None of this means that these investors are wrong to hold onto their “loser” stocks. As we know from every teen comedy made ever, today’s losers can turn into tomorrow’s winners.
So how can investors decide when they’re being rational (“I want to hold onto this stock because I still believe in the company”) or irrational (“I want to hold onto this stock because I can’t accept pain of realizing the loss”)?
One way is to avoid individual stocks, period, and invest in a total market portfolio of ETFs or mutual funds. This approach won’t protect investors from overall market declines and financial panics, but the goal of passive investing is to protect people from the mistakes of trading too often and trying to time the market, not to mention single-stock concentration risk, which is far more common than you may think. And let’s face it: a low-cost total market portfolio does alleviate the worry about whether the company you’ve chosen is a star… or a stinker that’s about to go to pot.
Editor’s Note: This article was first published on Daily Finance earlier this week.
Matthew Amster-Burton is a freelance writer and financial planner in Seattle.