Resist the October Effect
The “October Effect” refers, not to eating too much Hallowe’en candy but to the investors’ fear of a stock market crash that often coincides around the same time that carved pumpkins pop up on front lawns. Even though, historically, there are more drawdowns in September, by time October rolls around many investors have seen enough bad days and are ready to capitulate. For more than 100 years, from the crash of 1929 that marked the beginning of the Great Depression, to Black Monday in 1987, October is the month investors find most challenging. This is not only because no one likes to see the value of their portfolio decline but also because selling at an absolute or relative loss is psychologically hard—even for professional money managers.
Our aversion to selling losers is a type of cognitive bias that stems from the emotional loss being twice as painful as the joy we feel from a gain. In fact, we prefer to avoid a loss than get an equivalent gain. Not surprisingly, loss aversion is an obstacle to making good investment decisions.
It can cause us to avoid making an investment in the first place if there is a risk of loss. Or, we can stick too long with losers and miss out on better opportunities to create value and build wealth over the long term. To add insult to injury, investors are more likely to sell their winners but keep the losers! A study that applied the “cut losses early and let profits run” strategy to the past 100 years of the US stock market, found that it outperformed a static 70% equity/30% T-bill) portfolio by 1.4% annually and had lower drawdowns during the major stock market crashes in 1929-32 and 2007-09.
Getting better at selling is as important an investment skill as buying. There are several ways of managing loss aversion better. One is using the technique of framing which shows the sell transaction in a more positive light, such as a chance to deploy cash elsewhere or pay down a high-interest debt. This highlights the positive outcomes of selling a losing investment. Putting the loss into a larger context can also be helpful. The capital loss may represent only a small part of an investor’s portfolio or net-worth, so the sale is not catastrophic.
In my previous post, I wrote about the role of letting our investments compound in value. It’s important to understand that sometimes there are valid reasons to sell an investment. These could include tax-loss selling to offset capital gains, finding a better investment opportunity, a fundamental break in your original investment thesis due to a change in the company’s business or outlook, needing the capital to pay down a debt, and rebalancing the portfolio.
If you find it hard to sell, you’re in good company. A recent study shows that institutional investors who manage multi-million-dollar portfolios show proven skills in buying decisions but underperform in selling decisions, worse than even random selling strategies. Knowing when it’s time to harvest, by selling part or all of an investment, is an important tool in the investor’s toolbox.