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Oct, 2011
Realizing Losses: The Psychology of Investing

I am reluctant to realize my losses and you are probably reluctant to realize yours. Rational investors follow the maxim "Cut your losses and let your profits run." They are eager to realize losses quickly while they are slow to realize gains. Why then are we disposed instead to sell winners too early and ride losers too long? The answer to the puzzle is in our cognitive errors of mental accounting and hindsight, our emotions of regret and pride, and our inner struggle for self-control.

Buying a stock marks a hopeful beginning. We place the stock into a mental account, record its $100 purchase price, and hope to close the account at a gain, perhaps selling the stock at $150. As stock fate has it, the stock's price plummets to $40 during the following month rather than increase to $150. This is only a paper loss, we console ourselves. The stock's price would surely recover very soon and climb higher. We do not need to acknowledge our loss fully because it is only a paper loss. We do not realize the loss yet by selling the stock. The mental account containing the stock is still open, keeping alive the hope that losses will turn into gains.

Regret and Pride

We need not acknowledge our paper losses fully before we realize them, but we face them and they gnaw at us. We feel stupid. Hindsight error misleads us into thinking that what is clear in hindsight was equally clear in foresight. We bought the stock at $100 because, in foresight, it seemed destined to go to $150. But now, in hindsight, we remember all the warning signs displayed in plain sight on the day we bought our stock. Interest rates were about to increase. The CEO was about to resign. A competitor was ready to introduce a better product.

The cognitive error of hindsight is accompanied by the emotion of regret. We kick ourselves for being so stupid and contemplate how much happier we would have been if only we had kept $100 in our savings account or invested it in another stock that zoomed as our stock plummeted. Regret is painful enough when we face our paper losses, but the pain of regret is searing when we realize our losses because this is when we give up hope of getting even by recovering our losses.

Pride is at the opposite end of the emotional spectrum from regret. Pride accompanies the realization of gains. We congratulate ourselves and feel proud for seeing in foresight that our $100 stock would soon zoom to $150. Realizing gains by selling our stocks seals our gains and amplifies our pride. Regret is painful while pride is pleasurable, but both are teachers, warning us against behavior likely to inflict regret and encouraging us toward behavior likely to bring pride.

But sometimes the lessons of regret are overly harsh and the lessons of pride too encouraging. Stocks go up and down for many reasons and for no reason at all. We need not kick ourselves with regret every time stock prices go down, and we should not stroke ourselves with pride every time they go up.

Excerpted from What Investors Really Want. © 2010 The McGraw-Hill Companies. All rights reserved.

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©2011, Kelly Ruggles, Spokane, WA. Web site
Kelly C. Ruggles, Spokane, WA. is a fee-based financial planner located in Spokane.
Kelly C. Ruggles, Spokane, WA. President of American Reliance Group, Inc., a registered investment advisor.
Kelly Ruggles, Spokane, WA. is the author of "The Financial Playbook" for Retirement

Kelly C. Ruggles, Spokane, WA. Does not intend to provide personalized investment advice through this publication and does not represent the strategies or services discussed are suitable for any investor. Investors should consult with their financial advisors prior to making any investment decisions.