My dad asked me for advice once.
He had bought a condo in Myrtle Beach, South Carolina, several years back and was now wondering whether it was time to sell it and move on.
“Do you want to sell it?” I asked him.
“I’m really not sure. It’s complicated.” He replied.
“Do you want to buy it?” I continued.
“I already own it, Adam!”
“I know! But imagine for a minute that you didn’t already own it,” I continued. “If you didn’t already own it today… would you want to buy it today?”
After a brief pause, he said, “No! I wouldn’t buy it today!”
Well, there’s your answer, Dad…
Without realizing it, my dad had fallen victim to a mental glitch that psychologists call the disposition effect: our tendency to hold losing investments too long, hoping and praying to get back to break-even and avoid a loss.
That’s the urge my dad was fighting when considering whether or not to sell his investment, which hadn’t exactly turned out as he had expected it would.
Long story short… he bought in 2006, expecting to merely flip the pre-construction contract. When that plan unraveled, he began renting out the unit, but couldn’t achieve positive cash flow. Eventually, he relabeled the would-be investment “The Family Beach House” and merely visited as often as he or our family members wanted.
After years of this, my dad wanted to sell and move on. But there was just one thing holding him back… the roughly 10% loss he would lock in if he sold.
I suspected as much, which is why I asked him that question – “Would you buy it today, if you didn’t already own it?”
You see, the following two decisions are economically identical:
- Choosing to stay in an investment you already own; and
- Choosing to buy an investment you don’t already own.
In both scenarios, you are an owner of that investment tomorrow.
But psychologically, there’s a difference.
When considering a new investment, you don’t have to bother yourself with the psychological baggage of the investment’s past performance. You didn’t own it at the time… so who cares?!
But when considering whether to hold or sell an investment you already own… you have to face the psychological effects of how that investment performed for you. And in turn, you have to label yourself a “winner” or a “loser.” (And we all HATE being a loser, right?!)
So even though the money didn’t matter much to my dad, the psychological pain of adding one more tick mark to the “loss column” was almost too much for him to bear. He even admitted to me, “This deal didn’t go as planned, but I just wish I could get back to break-even.”
That’s the essence of the disposition effect. We feel a strong urge to hold unprofitable investments too long, simply because we can’t stand to admit defeat… and because the pain we feel when we lock in a loss is dramatically greater than the joy we feel when we lock in a win.
Psychologically, we walk away from losses – no matter how big or small – with a bruised ego, diminished self-worth, and a general lack of confidence in our investing prowess.
So we’re willing to try almost anything – mainly hope and prayer – to avoid locking in a loss.
It’s not a good strategy.
Yet investors routinely fall victim to the disposition effect (even without realizing it, most of the time).
I recently shared this story of my Dad’s condo with members of my latest research trading service, codenamed Project V.
It’s based on an unconventional market-timing strategy I developed to ride the cyclical waves of fear and greed that routinely pulse through the markets. We buy one ETF when in risk-on mode, and buy another ETF when in risk-off mode. That means Project V readers must be mentally prepared to “flip” positions routinely, buying and selling as conditions change.
And that’s something some people find a challenge, because our psychology – the psychological force of loss aversion – makes it difficult to give up on trades or investments that don’t go our way. The little devil on our shoulder whispers to us, “hold on just a bit longer… who knows, maybe this loss could turn into a win.”
That’s what happened to my Dad, when he couldn’t bring himself to sell his condo (for a small loss), even though he didn’t really want to own it any longer.
And even without their knowing it, loss aversion works against all investors – particularly those who don’t have a disciplined investment system, that tells them exactly when to buy… and exactly when to sell.
Don’t be a victim of your own loss aversion a day longer than necessary.
Editor, Project V