“I made up my mind to be wise and play carefully, conservatively. Everybody knew that the way to do that was to take profits and buy back your stocks on reactions. And that is precisely what I did, or rather what I tried to do.....
They say you never grow broke taking profits. No, you don't. But neither do you grow rich taking a four point profit in a bull market.”
Jessie Livermore, Reminiscences of a Stock Operator
We hate taking a loss, so taking a profit is always good, we usually think. After all, we’ve locked in our profits, so we can never take a loss on them. Which is all well and good, if you have a continuous stream of brilliant investing ideas, such that you can replace the stock you’ve sold with one that’s better.
This is worse than loose thinking, it’s not thinking at all. It’s not the profit we’ve made we should worry about, but the profit we’ve foregone. It’s the opportunity cost of selling a profitable stock we should be concerned over, not the transient orgasm that comes with the brief thrill of a quick gain.
“You never go broke taking a profit” is a horrible, thoughtless, dumb investing aphorism that deserves to be consigned to the Satanic fires along with tipsheets and day trading. It’s true, of course, but it justifies a whole raft of otherwise indefensible, idiotic and perverse trading behavior. Worse still, it panders to one of our most fundamental behavioral weaknesses, loss aversion. We just hate selling at a loss, so we will grimly hang on to loss making stocks.
The disposition effect, which is an outcome of loss aversion, adds to this the nasty twist that we tend to sell our winning stocks too soon – which means we no longer run the risk of a loss on that stock (see Brains, Bulls and Lucky Tossers). Of course, the problem is that we only track the stocks we hold. So here’s a tip: keep tracking the stocks you've sold and see what the results are. I can tell you one result – you’ll suffer from an alternative behavioral bias, regret.
The general idea about these biases is that they cause us actual pain. So selling at a loss hurts, and we…