Selling a stock at a loss is difficult for most of us because we have a loss aversion bias. It is common for investors to want to break even on an investment. Maybe you believe you should sell a stock but don’t because it is lower that the price you paid.
Studies show people fear the negative effects of loss twice as much as they enjoy the positive effects of an equal gain. In other words, people have a strong tendency to avoid losses and allow loss aversion bias to affect their investment decisions.
Myopic Loss Aversion
Myopic loss aversion is the combination of being more affected by losses and gains and the tendency to evaluate risk and outcomes too often. In other words, investors have a tendency to be too nearsighted and make poor long term investment decisions because of short term loss aversion.
Example of Loss Aversion
Let’s say Paul purchases a stock for $100 and three months later decides to sell the stock due to a fundamental change in the company’s outlook. The price of the stock is now $97. Like most of us, Paul doesn’t want to take a loss so he decides he will wait until the stock reaches $100 so he can break even and avoid a loss.
Let’s look at Paul’s risk/reward ratio and see if it makes sense. His potential reward for holding the stock is only $3 because he has decided to sell at $100. Paul has decided to risk $97 for the potential of making $3 more than he can receive today. Risk aversion bias has caused Paul to make a poor risk/reward decision.
Related Reading: Should the Price I Paid Affect My Decision?
If you have done your research and understand the intrinsic value of the company, the price you paid for the stock should not have an affect on your buy or sell decision. It is the current value compared to the price today that matters.
Don’t let loss aversion bias torpedo your investment returns. Forget about what you paid when selling a stock at a loss. What you paid for an asset has no bearing on the future price. Ask yourself; would this asset be worth buying now at today’s price? If not, sell it now!