Zacks Investment Management

Frank H. from Port Arthur, TX asks: Hi Mitch, I’m curious if you have any insights on knowing when to sell? It’s difficult for me anytime I buy something that goes up (can it go up more?) or if I own a loser that I don’t want to sell at a loss. Is there a good rule-of-thumb out there that I’m missing?

Mitch’s Response:

That’s a great question, Frank, and I know that plenty of investors grapple with this issue. I can see from your question that there seems to be a lot of emphasis on price, i.e., how much-unrealized profit or loss you have on a particular position driving whether or not you should sell. There is a hazard with this approach you should watch for, which is known as the “endowment effect.”¹

The endowment effect was coined by behavioral economist, Richard Thaler, here at the local University of Chicago (Zacks Investment Management is headquartered in Chicago). It says that the value you place on an asset greatly depends on whether or not you already own it.

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In other words, owning a stock with an unrealized gain will make you feel like a successful investor that is likely to be even more successful while owning a stock with an unrealized loss will make you think it’s only a matter of time before shares rebound. As you can see in both cases, simply owning the stock gets in the way of making an objective decision – investors want to be right no matter what.

Thaler and a group of economists started to close in on this type of investor behavior in the 1980s, when they ran an experiment using coffee mugs. There were three groups in the experiment:

• The first group had the option to buy a coffee mug;
• The second group could choose to receive either cash or a mug; and,
• The third group was given a mug and the ability to sell it.

When it came to assigning a price to the mug across the three groups, the value of the mug differed greatly based on whether or not a person already had it in their possession. The first group that had the option to buy the mug thought it should be worth $2.87, while the people who already had the mug thought its value should be $7.12.

When investing, it is important to consider that the endowment effect may be in play for stocks and holdings already in your portfolio. You may be reluctant to sell one of your winners that has gone bad or even to acknowledge that something has gone wrong. On the other end of the spectrum, the endowment effect could cloud your ability to see that one of your investments was never good to begin with.

One of the biggest features of knowing when to sell is getting past the endowment effect and staying true to your thesis to own. When you buy a stock or an asset, there were fundamental reasons for the purchase – do those fundamental factors still apply? Other questions to ask are if you did not already own the holding, would you buy it now? Or is there something else that better aligns with your strategy and thesis to own?

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