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Unavoidable errors

I say this because of new research on the disposition effect - investors' tendency to sell winners too soon and hold onto losers, thereby exposing themselves to negative momentum while depriving themselves of exposure to positive momentum. Economists at the University of Alicante studied this under laboratory conditions by getting subjects to trade artificial assets. They found that the disposition effect exists even when people are told that some assets are more likely to rise in price than fall while others are more likely to fall than rise: such knowledge should be a cue to run winners and cut losers, but subjects didn't take the hint. What's more, they also found that people are quick to sell winners even when transactions costs are high.

But here's the thing. There are two types of people who are especially likely to commit the errors of selling winners too soon and holding onto losers.

One type are those with strong self-control. These are too quick to sell winners, even after being told they are more likely to rise than fall. This could be because they apply the rule 'know when to quit' too inflexibly.

This gives us a paradox. In many contexts, self-control is a virtue. But in this case, it makes people bad investors by causing them to miss out on profits.

The second type of person prone to the disposition effect is the sort who hates to admit that he is wrong. Such people hold onto losing stocks because to sell would mean recognizing that they were wrong to buy.

Herein lies another paradox. Sometimes, refusing to admit that you are wrong can be a good thing. For example, Warren Buffett lost money during the tech bubble of the late 90s because his favoured stocks - quality defensive ones - fell out of favour. But in refusing to admit that he was wrong, he made a fortune when those stocks bounced back. Many other tech-sceptical investors who threw in the towel lost money.

What we have here are examples of a point made 2,500 years ago by Aristotle: virtues and vices are often the same thing but in different contexts. What is admirable courage in one context can be stupid recklessness in another, for example. Self-control, while useful in many contexts, can be a handicap when it causes us to miss out on momentum profits. And the ability to admit that you're wrong can be a good thing if it saves you from the disposition effect and exposure to negative momentum. But it can be a bad thing if it means you lack the discipline to stick to good principles. Having the courage of your convictions is a good thing. Pigheadedness is not. But they are the same thing, only in different contexts.

The ancient Greeks thought that the solution to these sorts of dilemmas was to use phronesis, the wisdom to know when to apply which characteristic in the appropriate circumstance - to know when to be stubborn and when to give in. Sadly, however, phronesis is as rare today as it was 2500 years ago.