Consider the following situation.
You bought a stock at $42 after it went down from $54 on an earning miss/fired CEO. The stock recovered to $50 and you feel quite smart about your “long term” thinking and due diligence. Fast forward a few months, the stock is trading in the $30 range because the new CEO resigned/was fired after a botched up acquisition and it seems that the problems might be deeper. But at $30 the stock is cheap and Seth Klarman has started buying. So, you buy some more to bring down your average price. Nearly 18 months later the stock has fallen to the $22 range and you buy some more because you are now in Klarman’s company. What could go wrong ? Few firings, few earning misses, bad board and serious threats to its core business later the stock is trading in the $15 range and it has been more than two years since you started your position.
(If you have not recognized the stock, I am very happy for you that you did not buy it. Because if you did, you would recognize that I am talking about Hewlett Packard, Ticker: HPQ).
Emotionally this stock drains you. You realize that your first buy was a wrong decision. You got in for only a 30% upside and you did not do your due diligence as deeply as you should have before jumping in. For example you did not realize that the company had a history of overpaying for acquisitions. The $38 billion goodwill and $8 billion intangibles as opposed to $40 billion in equity (figures from 2010) should have given you a clue.
(This example is entirely for an academic purpose. Every investor who has been investing for some time finds himself in a situation like this. Maybe not with HP but with a different stock which has its own set of problems. The idea is to show that these feelings are not unique and people who do not have the tools to deal with these biases end up buying high and selling low.)
If you were as smart as you are now, you would have started buying around $30 and you would not be in such a deep hole. Other times you think of just selling the position and taking the loss. Just for the sake of mental peace. You are fed up of seeing this position spiraling towards abyss with no hope of a turnaround in the price. Why not just sell the position and avoid the opportunity cost of keeping your money tied to this stock? You can buy Tesco Plc or Applied Materials. They do not suffer from a retarded/greedy board and bad management.
But then again, you think that these are all paper losses. The stock will recover (probably not soon) and you will get your money back. You realize that the fair value of the company is definitely above $30. At these prices the company is selling for a lot less than its sum of parts. The personal computer group of the company can be given to charity and the company will still be cheap. At $15 the company is too cheap to ignore. You curse yourself that you should have started buying NOW! Not two years ago! At $15, can you afford not to buy?
So, we come to the inevitable question. Should you sell for your mental peace or should you ignore your misery and buy some more?
(Just to summarize. We are talking about a stock, not so great, in which you have a position which is underwater in the range of -60%.)
If we can shut off our emotions, probably the decision will be much easier. We will not be confronted with this emotional drain which hits us every time we think about it. For people who look at their positions every day, the toll is extraordinary still. Is the position worth taking this incessant hit for?
Amos Tversky and Daniel Kahneman did some seminal work in the area of loss aversion. Loss aversion refers to the tendency of people to avoid losses compared to acquiring gains. Some studies suggest that losses are more than twice as powerful as gains.
I remember the following chart from a webcomic a few weeks back. It is quite true.
(The idea is from a webcomic I read a few weeks back. If someones remembers it, please comment and I will put in the appropriate reference.)
Antonio Damasio and George Loewenstein did an experiment by inventing an investing game. They took three groups of people. Group A consisted of patients who had suffered damage to the emotional part of the brain (i.e., probably did not feel a lot of emotions), Group B had patients who had suffered damage to some non-emotional part of the brain and Group C was controlled consisting of undergraduate students.
The experiment consisted of 20 rounds of the following game. At the beginning of the round each subject was given $1. He was asked if he wanted to play the following game. A coin will be tossed in plain view. If he won, he will pocket $2.5 and will lose the $1 if he lost. If he decided to not play the game then he can pocket the $1 given to him and the game will advance to a new round.
Assuming that the coin is fair, the expected payoff for “investing” in a particular round is $1.25 (0.5*($2.5) with the 50% probability of you winning $2.5) and is $1 if you do not invest. If you invest in each round then the probability that you will make less than $20 is less than 13% ($20 is the amount you will have if you did not invest in any of the 20 rounds).
Two facts were observed from the study: 1) Group B and C, who had their emotional parts intact chose to invest in only 58% of the rounds as opposed to the Group A with emotional damage who invested in 84% of the rounds, and 2) Immediately after a loss, Group A invested 85% of the time while Group B and Group C declined further participation. The willingness to gamble went down immediately after a loss.
This simple experiment explains a lot. It explains why people buy the security of low yield bonds than profit from the upside of stocks. It also explains why after a loss people decide to not invest for a while. Some people give up investing entirely because they think that it is not their cup of tea.
It is settled that part of the emotion I face regarding HP is not rational. The emotional toll is a by-product of the loss aversion bias and I realize that losses are much more powerful than gains. Knowing that it is easier for me to handle the situation. It is good to call the bluff of of my emotional self.
Consider the following situation.