Tuesday, 1 April 2014

20% Gain = Happy Disposition?

The results are in: the total return on the DIY Income Investor portfolio for the 'financial' year 2013/14 (I measure it as 1 April 2013/1 April 2014) is a sliver under one-fifth (19.5% to be precise). Not too shabby - but less than the near-30% in the previous year.

Still, it seems that I could have done better...

The 'Disposition Effect'  is the widely-observed tendency of investors to sell their 'winners' too quickly and to hold on to their 'losers' too long. The effect was so named by Shefrin and Statman in 1985 ("'a disposition to 'ride losers'") and is an extension of Kahneman and Tversky's 'prospect theory' work in 1979, extended to the field of investment.

The reason for this behavioural bias is not entirely clear to the clever academics. One possible explanation is that is at least partly due to a belief in 'mean reversion' - that current 'losers' will out-perform their current 'winners'. Certainly, a key element is 'anchoring' on the purchase price as the reference point for future decisions to buy and sell.

[I confess to both of those biases.]

Behaving this way costs money: sold 'winners' tend to go on to produce greater gains (3.4% to be exact) than the 'losers' that are held on to (according to Benartzi and Taler, 1995, who also estimated that the average investor's time horizon was one year - as reported in Odean's 1998 paper). The average investor's gain on selling a 'winner' appears to be around 28%, whereas the loss on selling 'losers' is around 39% (assuming the selling price of both stocks is £1000 the respective gains and losses would be +£217 and -£647). One year later the 'loser' share price will have declined by 1% and the 'winner' share price will have improved by 2.4%, relative to the market as a whole.

[That chimes with my typical 'gain' on winners of around 30-45%. The loss on losers is much more variable - but then I haven't sold many of them!]

Perhaps the answer is a stop-loss. I have in place a 'stop-gain' (equivalent to five-years'-worth of annual income) - but I don't really use stop-losses. Recent research (thanks Vatsa) has shown that for momentum investing a daily 10% stop-loss can significantly reduce overall losses - and thereby improve the portfolio performance.


I am not a financial adviser and the information provided does not constitute financial advice. You should always do your own research on top of what you learn here to ensure that it's right for your specific circumstances.


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