The Reluctant Investor
Do You Pick the Flowers & Water the Weeds?

The Reluctant Investor courtesy of

In light of recent market volatility, it's a good time to dip into broker-speak and pose the question: Do you pick the flowers and water the weeds?

But let's get real, we're not talking about gardening here. Academic studies suggest that individual investors tend to sell their winning stocks and hold their losers, much to their financial detriment.

A recent study conducted by Terrance Odean, an assistant professor at the Graduate School of Management at UC-Davis, examined 10,000 trading accounts from a "large discount brokerage house" between 1987 and 1993. Odean found that during a given year, investors realize, or cash-in on, their winning stocks more frequently than they get rid of their losers by a ratio of approximately 3:2.

(A "loser" is defined as any stock that is currently trading below the price at which it was purchased. A "winner" is a stock trading above the price at which it was purchased.)

What does this mean, you ask? Nothing, until you look at the performance of the winners that were sold. Odean monitors the stocks' performance after the sale and compares it to the Center for Research in Securities Prices (CRISP) value-weighted index. The sample stocks outperform the CRSP index by 0.47% after 84 trading days and by 6.45% after 504 trading days. The winners kept going up after they were sold. It would have been nice to hold on a little longer.

Conversely, losers under-performed the CRSP by 0.56% after 84 trading days and by 1.06% after 252 days (one year of trading days). By selling the winners too soon and holding the losers too long, these investors are doing themselves a huge disservice and would be better off doing the opposite.

Dumping losing stocks and declaring the loss can also help you avoid the tax-man. It can even prove profitable - most people qualify for a $3,000 write-off on stock market losses. Watch the market dip during the last few weeks of each year as investors in-the-know ditch their losing stocks in order to lower the tax bite.

And losses, for tax and performance reasons, often make attractive sells when re-balancing or fine-tuning your portfolio.

What's the moral? Separate mind and money. Flowers should by cultivated and savored, not cut and put on display as a tribute to your investing acumen. Investors are too quick to acknowledge their trading genius by selling at any profit and too slow to admit errors by selling the duds before the losses mount. Odean cautions against letting your ego guide your investment decisions.

Odean's research, including the article, "Reluctant to Realize Their Losses?" can be found on the Web.

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Links from this page:
CRSP - http://www.crsp.com/

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