There’s a maxim in investing that you should cut your losers and run your winners. But the problem is that individual investors tend to do the opposite. Research shows that profitable stocks are often sold too soon, while losing stocks are held too long (in the hope they’ll recover) - and that damages returns. It’s a behavioural bias so well known that it has its own name - the disposition effect. The good news is that the humble ‘stop loss’ could be one way of avoiding this particular emotional trap.

What we know about selling losers

Joel Greenblatt tackles the issue of selling shares in his book, You Can Be a Stock Market Genius. In typical forthright style, he says: “The bad news is that selling actually makes buying look easy… however, here’s a tip that has worked well for me: Trade the bad ones, invest in the good ones.”

Greenblatt stresses that this advice isn’t quite as useless as it might seem! His point is to know the kind of company you’re buying and hold it for as long as it performs as you expect. That might mean cashing out early from shares that suddenly face an uncertain future. But other positions might be held for many years. The logical conclusion is that you should sell badly performing positions as soon as possible.

Greenblatt’s comments echo the advice of many successful investors. For instance, it’s been noticeable in all my recent interviews with highly successful UK investors, that they all take a similar line on selling losers. In simple terms: get out early and you’ll feel a lot better. Fund manager Mark Slater has a general principle of selling on bad news, Robbie Burns advocates strict stop-losses, while Lord Lee of Trafford also advises having a fixed plan on when a holding should be sold. I know that the subject of my next interview, Giles Hargreave, takes a similar approach.

In academic literature, the statistics on the trend for investors to hold losers speak for themselves. When I’ve written about the disposition effect in the past, I’ve mentioned work by Terrance Odean. His classic study of 10,000 accounts at an American broker between 1987 and 1993 found clear evidence of investors selling winning positions over losing positions. And they paid the price - on average the losing stock that was held…

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