Do you suffer from getevnitis?4 min read . Updated: 01 Jul 2014, 06:57 PM IST
Investors should start listening to the planner in them and stick to a discipline in investing
Behavioural economists have shown that investors, especially the retail ones, exhibit a tendency to sell their winning stocks rather too quickly and a reluctance to get rid of their loosing stocks. Investors often take these actions going against their own rational judgment. This tendency has been termed as “disposition effect" by Hersh Shefrin and Meir Statman. However, such actions prove expensive to investors as the stocks they sold tend to move up, and vice versa. Experiments conducted in our lab as well as prior research on Indian investors reveal that Indian investors are equally prone to the disposition effect.
Consider an investor who bought a stock for 100 sometime back and its current price is 110. According to this investor’s own calculations, there is a 60% chance that the stock will gain 10 and a 40% chance that it will lose 10. Research shows that in such situations, most investors, being risk averse, decide to liquidate their portfolio although such an action is sub-optimal ex-ante. Now, imagine a slightly different case. Assume that the current stock price is 90. This implies that our investor is sitting on a paper loss. In addition, assume that the investor believes that there is a 60% chance that the stock will lose another 10 and a 40% chance that it will gain 10. In most such cases, investors tend to hold on to their stocks hoping to get even, although it is optimal to sell the stock. Therefore, the disposition effect is also called getevnitis disease.
Nobel winning behavioural economist Daniel Kahneman and his co-author Amos Tversky, in their famous prospect theory, argue that investors tend to evaluate their portfolios from an artificial reference point. In most cases, purchase price of a stock turns out to be the reference point. From then on investors view their portfolios as gains and losses from the reference point. Secondly, most investors are risk averse. Disutility from a loss is much more severe than the utility arising from an equal gain. There is asymmetry in our perception of gain and loss. In other words, the pain an investor experiences after losing 100 is substantially higher in magnitude in terms of its absolute value than the pleasure the same investor experiences when she gains 100. This makes investors hold on to losing stocks.
Economist Richard Thaler explains the phenomenon through the framework of mental accounting. Investors tend to open separate mental accounts for each stock they purchase and the purchase price serves as the reference point. Selling a stock above the reference point evokes a feeling of pride and selling it below evokes regret.
Author Le Roy Gross puts it bluntly when he says that investors who realize losses “can no longer prattle to their loved ones, ‘Honey, it is a paper loss, just wait, it will come back’. On the other hand most investors tend to show eagerness to “book profits" as they do not want to miss the feeling of pride and opportunity to brag about their superior judgment.
Professional traders understood this phenomenon long back even though they have not formally modeled the same. In his famous book titled Reminiscences of a Stock Operator, written in the 1930s, Edwin Leferve claims that it is important to sit tight when one is right. Unfortunately, it has been consistently shown that disposition effect results in large losses to investors.
Sankar De and Rahul Chhabra, who are studying the impact of disposition effect on Indian investors, also show that such tendency is detrimental for wealth creation. A number of studies have shown the same to be the case in the US and other developed nations.
Now the important question is how do we deal with this getevnitis disease? The answer, as in most cases, is easy to preach but difficult to practice. Let’s consider investors who would have bought Oil and Natural Gas Corp. Ltd (ONGC) at 415 expecting a gas price hike. Assume that investors believe that true value of ONGC with a gas price hike is 500 and without a gas price hike is 350. If the government does not increase the gas price, such an investor should not hesitate to the sell the stock. On the other hand, if the price hike comes through, the stock must be held until full value is realized. The important point here is that the purchase price has nothing to do with ONGC’s value and hence, should not be considered in decision making.
Researchers have pointed out that all of us have a planner and a doer sitting in our head. It is the doer who gets swayed by feeling of regret and pride and ignores the sensible advice given by the planner.
It is important that investors start listening to the planner in them and stick to a discipline in investing. Else, not even a bull market can help.
Prasanna Tantri, associate director, Center For Analytical Finance, Indian School of Business.