Cutting Losses

Itzhak Ben-David is a prominent economist in the United States. In 2012, he co-authored a ground-breaking paper, which was titled “Are Investors Really Reluctant to Realize their Losses? Trading responses to past returns and the disposition effect” (Ben-David & Hirshleifer, 2012). As the title suggests, it studies how retail investors to enter and exit as their positions develop.

Ben-David and Hirshleifer studied stock transactions from more than seventy thousand accounts at a discount broker from 1990 to 1996. They tried to find patterns of how investors bought their shares, when they made the sale, and how much they earned or lost with each position. They also wanted to see at what times the investors would add to their positions. The results of their findings were published in the August 2012 issue of the Review of Financial Studies.

They discovered some very interesting behaviour of these individual investors:

■ They held losses longer than their gains.

■ They preferred small gains to small losses.

■ They add to a loss more often than to a gain.

Behavioural economists called this the disposition effect. A simpler way to put it is that most investors do not want to recognise losses. When they have a small win, they hurry to take it off the table as soon as possible, because they fear that it will reverse and turn into a loss. On the other hand, when their position shows a loss, they rationalise that it is a good investment and it will rebound one day, so they keep holding onto it as dearly as their lives.

Unfortunately, this is not exactly the best way to stack the odds in one’s favour. If an investor is only willing to make small gains, and at the same time unable to limit his losses, then one large loss will be expected to wipe out all the profits. Worse yet, if the investor suffers from consecutive large losses, then he will have a hard time to recover as his average wins are so small. In the long term, his prospect of staying afloat in the stock market is not very optimistic.

In addition, if one is unable to limit his losses, then he will soon discover that the road to recovery is a long and hard one. For example, if you lose 10%, you only have to make 11% to break even; if you lose 30%, you will have to make 43% to return to the original amount; but if you lose 50%, you will have to make a whopping 100% to recover. Which one is easier, not losing 50% or winning 100%?

Famous trader Mark Minervini once conducted a private study to demonstrate to effectiveness of cutting losses (Minervini, 2013). He used to be a trader who did not have a strict discipline in deciding when to get out of a position. At one point of his career, he pulled out his trading record, and analysed it to see what the difference it would make if he had stuck to a strict 10% stop loss policy. The result was stunning. Even though the stops did get him out of some winning trades, it saved him a lot more on the downside, and could have improved his performance by 70%!

To be successful in the stock market, an investor must keep in mind that the first rule of the game is to protect his capital. Avoiding large losses is just as important as having big gains. In the end, you cannot determine how much the share price will eventually go up, but you do have full control in deciding how much you want to lose. If you cannot get used to taking small losses, then sooner or later you will have to get a much larger one.

REFERENCE:
Ben-David, I. & Hirshleifer, D. (2012). Are Investors Really Reluctant to Realize their Losses? Trading responses to past returns and the disposition effect. The Review of Financial Studies, 25(8), August, (2012):2485-2532.
Minervini, M. (2013). Trade like a Stock Market Wizards: How to achieve superperformance in stocks in any market. New York, NY: McGraw-Hill Education.