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This topic contains 3 replies, has 2 voices, and was last updated by  Erik Kobayashi-Solomon 10 months, 1 week ago.

  • #9617

    Wilson
    Participant

    I noticed that when a stock I own drops significantly, I have a tendency to sell it after I break even on it despite it still being undervalued.

    How can I avoid doing this?

    #9622

    Hi Wilson,

    Thanks for the question. This is something that I talk about in the 101 course on Behavioral and Structural factors, actually. It is an effect that Kahneman and Tversky wrote about in their seminal paper, “Prospect Theory”. The idea behind classical economics is that economic actors are rational. In other words, that they are willing to bet only the probability weighted amount of an outcome of a game of chance. For example, if someone asked you how much you would pay to play a game that if you guessed a coin toss, you would win a dollar, it would be irrational for you to bet any more or less than $0.50.

    What Kahneman and Tversky realized was that very few people actually operate this way. When people are losing, they are more willing to bet (i.e., they would pay more than $0.50 for the chance at a coin toss wager — this behavior is termed “risk seeking”) and when they are winning, they are less willing to bet (i.e., they would pay less than $0.50 for the chance at a coin toss wager — this behavior is termed “risk aversion”).

    This kinked utility curve has spurred the trader's maxim “Let your winners run and cut your losers short.” The trader's maxim is hard to do psychologically, but it does combat the Prospect Theory effects.

    This is a very, very difficult bias to combat. A few things that I do are:
    1. Refrain from making decisions when I'm undergoing emotional stress regarding a position.
    2. Recheck my valuation work (This can backfire, because if one is emotionally triggered, one can find “good” reasons to pull one's valuation assumptions down. See the first rule… I will check my model, but if I am feeling agitated — or excessively happy — I will not make changes.
    3. Don't check prices as often. A colleague at a hedge fund at which I worked would wait till after the market close to check market prices on the Bloomberg. I thought it was silly when I saw him doing it at first, but I've grown to appreciate the wisdom of it.

    Hope this helps!

    All the best,
    Erik

    #9624

    Wilson
    Participant

    Thanks for the suggestions. I'll give them a try.

    #9625

    These biases are very deep and hard to get clear of. I'm constantly checking myself and have to coach myself sometimes on this point. “Maybe it is time to think about selling, but let's let some time pass and rethink when fresh.”

    The one thing that I usually find is destructive is reacting when emotional… This is, I think, Buffett's point: “What's needed is a sound intellectual framework for making decisions and the ability to keep emotions from corroding that framework.”

    All the best,
    Erik

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