One of the basic rules for active investors is to sell your losers but let your winners run.
It can be more profitable to protect against losses than to search for gains.
Once an investment has deteriorated it should be sold to avoid losses eating into profits made elsewhere in the portfolio, however, this is one of the hardest things to do.
In 1998 research at the University of California discovered that investors are 50 per cent more likely to sell winning stocks to bank a profit rather than sell losers to avoid further losses.
The study showed that fund managers in the United States who were reluctant to get rid of their poor performing assets underperformed their more ruthless colleagues by up to four per cent per annum.
This confirms that there is a great deal of psychology to the process of managing investments and a recent book by Noble Prize winning Israeli-American psychologist Daniel Kahneman called Thinking, Fast and Slow identifies some of the traits that let investors down.
Kahneman’s most celebrated example of the downside of answering questions with an instant response was “The Linda Problem”. Devised with a fellow psychologist the late Amos Tversky, the experiment involved telling participants about an imaginary young woman called Linda who was a very bright student deeply concerned with discrimination and social justice issues..
Those involved in the experiment were then asked which was more probable: Linda becoming a bank teller or becoming a bank teller involved with the feminist movement.
Among students in Stanford University’s Graduate School of Business, 85 per cent gave the wrong answer saying she was more likely to become a feminist bank teller ignoring the reality that every feminist bank teller would be a bank teller.
Kahneman’s ability to illuminate this typical human trait across all fields enabled him to earn the distinction of becoming the first non-economist to receive the Nobel Prize for Economic Sciences in 2002 for highlighting the breakdown in rationality often found in intuitive instant decisions.
Selected one of the best books of 2011 by the New York Times, Thinking, Fast and Slow illustrates there is a fine dividing line between confidence and overconfidence and the latter can lead us to believe that we cannot be wrong when making investment decisions.