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Loss Aversion : Fear of Loss is More Powerful Than The Hope For Gain!

Everyone knows that you should buy low and sell high…but most of the investors do exactly the opposite. They start panicking and sell when the market goes down and start cheering when the market goes up…and would end up buying when the markets are at the peak.

When you go to a mall or super market and if the prices have come down…there is discount sale…wouldn’t you be happy? You are getting to buy the same stuff at a much cheaper price…it’s almost the same with stock markets…when there is a market correction/crash…you are getting to buy good companies at much better prices…and if you already hold some shares…you can buy more and bring down the cost and make better profits when the markets move up…

One of the big decisions in stock investing is …when to sell? The easy answer is never  . An investment of Rs 10000 in wipro’s share is 1980 is currently worth more that Rs 500 Cr and there are many investors who never sold and passed on the shares to the next generation.

Here are some real examples – Source ET
Ashish Pahade – “I have inherited these shares from my father. Why should I sell them?” The stock was bought for a few hundred rupees in the 1970s and is now worth more than Rs 5 crore. Using his dividends, Pahade has started a small-time lending business.
Arvind Muthe didn’t realise he owned the stock until a friend spotted his name in the list of shareholders in the annual report. The value of the shares his father left him was a few crore rupees, more than enough to pay off his debts and get out of a jam.
The Daga family— two brothers and three sisters — inherited shares from their father. Their combined holding of 5 lakh shares is currently valued at about Rs 28 crore

This is just one example of wipro..there are many investors in India who have done the same with shares of Tata, MRF, Reliance, infosys etc where investors have held on to the shares for a long time. So if you have bought share of good companies…you should hold on for long and sell it only when the fundamentals start deteriorating in a company.

But this is easier said than done…and it is more difficult for people who are close to the action.

Imagine you have built a portfolio of 15-20 stocks, Over a period of time some of them will go up and some may come down. Most of the retail investors will do the exact opposite of what they should do. They sell the winners and they hang onto the losers. Its like Peter Lynch said “Cutting the flowers and watering the weeds”. This sounds foolish but it’s actually the net result of two concepts: profit-booking and loss aversion.
When a stock starts rising, many investors want to ‘book profits’, that is, sell the stock and get the gains into their own bank accounts. As the stock price rises, they get nervous about future falls and feel that a bird in hand is worth two in the bush. Typically, many equity investments get ‘profit-booked’ after making 20-40 per cent of the gains. I’ve seen on many an occasion that investors identify a good investment, invest in it and then sell it after such moderate gains, only to see the stock grow many times.

The opposite side of the story is just as tragic. When an investments starts declining, investors don’t sell out quickly enough. This is the opposite – an aversion to admitting a loss. As long as a stock is held, one can always convince oneself that it will turn around, the original theory will be proved right, and there will be a profit. Psychologically, selling the stock and booking the loss means admitting a mistake, something which all of us hate. Yet the logic of arithmetic is impeccable. If a stock falls 25 per cent, it will need a 33 per cent gain to just break even. If it falls 50 per cent, it will need a 100 per cent gain.
A combination of profit booking and loss aversion means that many investors don’t gain enough from their good choices and lose too much from their bad choices. How do you remove these two roadblocks in the path of getting great returns?

Also, for retail investors the available insight and research is limited…we may be able to identify good companies based on financials, past performance etc.…but it is difficult to track and analyse management actions and its future impact on the company, Impact of macro & political factors etc and hence the fear…if the company will continue to perform as it did in the past…

But again the big money has always been made by Identifying good, scalable business bought at good valuations and held on for long…for many of us who can’t strictly follow…Here is what I do…

Create two accounts with two separate brokers or with the same broker on another family members name..
Divide the investable money and use 50% to follow pure fundamental/value strategy and hold it for long term, sell only if the fundamentals deteriorate and use the other 50% to buy the same set of companies on the other account but book profits occasionally…don’t book small profits…I usually wait for it to double if I really like the company or at least up by 50%. Also, before booking profits, ensure to identify any other company to invest. For companies which have not moved or have gone down…stay invested on both the portfolios if the fundamentals are intact otherwise Exit.

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