Think investor. Moderating the pain of taking loss

Cutting losses on investment is easier said than done. This is because we hate losses more than we like gains of the same magnitude. That is, a loss of ₹10,000 will cause more pain than a gain of ₹10,000 can give us happiness. This behavioural bias, called loss aversion, adversely impacts wealth. Here, we discuss how loss aversion can hurt financial well-being. We also discuss how to manage your emotions when cutting losses.

Managing emotions

Suppose you fail to cut losses in your trading portfolio when the position moved adversely. You expose yourself to the risk the stock will further move against you and cause more losses. Also, you lock-in capital in a loss-making stock, thereby, denying yourself the possibility of generating gains by investing the money elsewhere. If you continue to display such loss-aversive behaviour, you could unintentionally build a large portfolio of such stocks. These stocks may eventually go up in price, but your capital may be locked up for a long time. And, that is not optimal.

You can manage your loss-aversive behaviour by pairing loss-making stocks with profitable trades. Suppose you have three stocks in portfolio, one of which has an unrealised gain of ₹10,000 and other two have combined unrealised losses of ₹4,000. Selling each of the loss-making stocks separately can cause pain, as the loss will be salient. But you can pair these loss-making stocks with the one that has unrealized gain.

Your net gain will be ₹6,000. Of course, you will regret incurring the losses, but the pain will be less because it is subsumed within the gains. Note that pairing the stocks require you to identify the ones that need to be sold based on your view of their directional movement from the current levels. That is, your decision must be based on the profit-making stock reaching its price target and your view that the loss-making stocks are unlikely to move up soon.

Conclusion

The objective is to reduce the pain of taking losses so that you release the stocks that are no longer optimal to hold in your portfolio.

You can also consider pairing two-three loss-making stocks when you do not have profit-taking stocks to pair with. The objective then will be to take a large loss with high-intensity pain. This is arguably better than selling one loss-making stock each day, incurring a series of moderate level pain!

(The author offers training programmes for individuals to manage their personal investments)