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Do you have a case of “get-evenitis”?

|Includes: IWM, SPDR S&P 500 Trust ETF (SPY)

While not a terribly sophisticated term, get-evenitis refers to the tendency of individuals to NOT cut losses short, and instead hold on to losing investments until they can be sold at the break-even price paid for it. This happens because realizing a loss is painful, while its easy to feel good about selling something at a gain. As a result, investors tend to sell winners too soon, and hold onto losers for too long.

The main psychological effect at work in these cases is something known as “loss aversion.” This phenomenon was studied at length by Daniel Kahneman and Amos Tversky in their work on prospect theory. In essence, they discovered that people dislike a dollar loss roughly two times more than they like a dollar gain. As a result, humans are more likely to avoid taking a loss from where something was bought, selling paper gains instead of paper losses.

The implications of this can be quite significant over the long-run. A study by Terrance Odean in 1998 studied customer accounts at national brokerage houses. He discovered that a stock that was at a gain from where it was bought was 70% more likely to be sold than a stock which was below its purchase price. Furthermore, the gains made were not necessarily large. In other words, people cut their GAINS short, and left their losses to get bigger and bigger, hoping for a comeback.

This can be quite detrimental to long-run returns. First, there are tax advantages to taking losses, and tax disadvantages for capital gains. When you sell at a loss, you get a tax rebate. When selling at a gain, your gain is taxed. On top of that, it turns out that if those individuals in Odean’s study actually held onto their winning investments just one year longer, those investments would have outperformed the market by a little over 2%, as opposed to holding onto the losers for another year which would have on average underperformed the market by roughly 1%.

The Take-Away
Be true to yourself, and know what the research shows. Instead of wanting to sell an investment at a gain or holding an investment at a loss, don’t use the price you paid for the investment as your reference point. Instead, always ask yourself whether there is a better opportunity and don’t let hope of getting back to break-even affect your ability to better put your money to work elsewhere.

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Disclosure: The author, Pension Partners, LLC, and/or its clients may hold positions in securities mentioned in this article at time of writing.