People Are Afraid to Let Their Winners Run
Published 9 April 2020
By Dr Peter J Phillips, Associate Professor (Finance & Banking) University of Southern Queensland
Anyone who has invested for any length of time will be able to recount a story about an investment that they sold ‘too soon’. Even Warren Buffett, one of the greatest investors in the world, has made that ‘mistake’ more than once. For example, he sold his firm’s stake in McDonald’s too soon and admitted as much in his 1998 annual letter to shareholders.
In 1996, Buffett’s Berkshire Hathaway held almost 30 million shares of McDonald’s stock. The price of the shares at the time was around $23. The share price in 2020 is almost $200. However, this is not the whole picture. The stock was split 2-for-1 in late 1990s, meaning that Buffett’s stake would have doubled to 60 million shares. So he would have turned a $690 million investment into a $12 billion investment. By the end of 1998, though, Buffett had sold off almost the entire position. Even the best of them make the occasional mistake (though hindsight is a wonderful thing).
There is a classic paper in finance about this type of behaviour. It is Shefrin & Statman’s (1985) “The Disposition to Sell Winners Too Early and Ride Losers Too Long: Theory and Evidence”. It was published in the Journal of Finance.
Shefrin & Statman wanted to test a hypothesis about human behaviour that can be found in Kahneman & Tversky’s (1979) work on economics and psychology. In that work, Kahneman & Tversky had found that people tend to become risk averse once they are in the ‘domain of gains’. They act more conservatively to protect the gains they have made. On the other hand, when they find themselves in the ‘domain of losses’, people tend to become more risk seeking. They act more aggressively in an attempt to recover lost ground. This type of behaviour appears rather general and might be found in many settings including, say, organisational settings in which people are attempting to achieve some sort of career related goal. It might even explain how Australian football teams react during a game.
Shefrin & Statman hypothesised that this type of behaviour might translate into a stock market setting. If so, investors would display a tendency to sell winning investments too soon (because the investor becomes conservative in the domain of gains) and hold losing investments too long, or even add to a losing position (because the investor becomes aggressive in the domain of losses).
Using data on individual trades made by investors, Shefrin & Statman found that there was indeed a fairly marked tendency to avoid the realisation of investment losses. Although part of the explanation can be found in non-behavioural (taxation related) factors, those factors could not fully account for the disposition to realise gains far more frequently than losses. Approximately 60% of the time, when investors engage in a trade that involves selling an investment they had previously purchased, it is to realise a gain. Losses, by contrast, are only realised about 40% of the time!
It seems, people are afraid to let their winners run.
Discussion Question
Think about a situation where you have made a loss. Did you have a feeling that, perhaps, you could hold out a little longer and maybe avoid making that loss permanent? Do you think this type of feeling explains why people are afraid to let their winning investments run?
Further Reading
For those interested in researching this topic further, see chapter 7 of Financial Institutions, Instruments and Markets 9e where behavioural finance is discussed alongside some of the orthodox theories of share price movements.