Why it’s so hard to run winners

Ever taken profits on an investment at the slightest whiff of volatility only to see its share price soar higher a few days/weeks/months later? Dont despair, most of us struggle to keep our fingers away from the sell button, even when things seem to be going swimmingly. Heres why.

Know your enemy

The tendency of investors to sell their winners (and retain their losers) is what behavioural finance boffins call the disposition effect. It happens because were primed to do what makes us feel good and avoid things that cause regret.

The disposition effect has its roots in the work of psychologists Kahneman and Tversky. They believed most people looked on losses and gains differently. When faced with two options, were more likely pick the one presented in terms of potential gains over the one presented in terms of possible losses.

Heres an example. If Iwere to give you the choice of a) winning 20 or b) winning 40 and then losing 20, what would you do? Research shows that people would pick the option a), simply because were hardwired to avoid the greater emotional impact caused by option b). By choosing the latter, wed inadvertently make 40 our reference point. To then walk away with anything less would feel like a loss, even though the actual choice doesnt matter you get a crisp 20 note whichever option you go for.

It works the same way in investing. Were far more likely torealise a small gain rather than hold on for a potentially far larger one because the pain wed feel if the latter were to then reduce would be too great. Besides, a profit is a profit. It feels good to be right.

To make matters worse, we cling to losing stocks. After all, in addition to hurting financially, it would involve usacknowledging wed made a mistake at some point in our selection process.

The real kicker in all of this is that research has shown that the stocks sold by investors (the winners) tend to continue outperforming the losers they hang on to.

To be clear: over a long enough time period, the disposition effect could seriously reduce your chances of achieving financial independence.So, knowing that we have a habit of behaving like this, what can we do to reduce our susceptibility to it?

Resist temptation

Start by ignoring your gains. Instead, focus on re-evaluating your winner. Was the companyundervalued to begin with? While it now trades at fair value, thats still no reason to sell if the story hasnt changed. Even companies with seemingly inflated valuations can be worth sticking with if the future looks rosy. Thats why I remain invested for now in companies like Blue Prism and boohoo.com, despite both registering incredible share price gains over the last year.

Also consider the consequences of selling. Is it worth taking profit on a seemingly great company to reinvest in what might turn out to be a very average alternative? If its true that great investors hang out with great companies, why leave the party so soon?

Remember that successful investing is not about how many winners you own but how profitable they are. A few great stocks held for the long term can be far more rewarding than a portfolio full of average ones.