Sunday, June 8, 2014

The "endowment bias" with stock selling decisions

John Authers points to the risk aversion bias arising from the endowment effect that distorts traders selling decisions. He writes that the "effects of poor selling decisions outweigh good buying ideas",
Inalytics, a London-based investment research group, broke down the effects of all 45,000 trades made by a group of pension funds between December 2003 and September 2006. Buying decisions on average improve returns compared to the relevant benchmark index by 0.47 percentage points – suggesting their stockpicking added a little value for clients, at least before fees. But the selling decisions added up to a negative impact of 0.94 percentage points, exactly double the positive impact of the buying decisions.
Evidently, selling decisions pose a dilemma. In good times, there is the risk of selling too soon without capturing the full upside gains. In bad times, there is the risk of staying invested too long as to further increase the losses. In other words, the dilemma is between managing the risks of maximizing the upside when the markets are rising and capping the losses when markets are tanking. The greater danger arises from holding on to losing stocks for too long in the hope that it will rebound. Therefore a good trader must "ditch the emotional baggage that makes selling harder than buying", and one way to do this is to limit the endowment bias by down-playing (or even masking) the purchase price.

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