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Financial Decoder: Episode 1


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In this episode of Financial Decoder, host Mark Riepe, head of the Schwab Center for Financial Research, examines the psychological forces that impact a common investing decision: What should you sell?

Investors often spend a lot of time and energy trying to decide which investments are the best to buy. But what about when it is time to sell? In this episode of Financial Decoder, Mark shares what the research tells us about the psychology of the sell decision. Choosing to keep or to sell a stock or other investment can be complicated because of something called the disposition effect. Joining Mark in the discussion is Omar Aguilar, chief investment officer for equities at Charles Schwab Investment Management, who talks about the way professional money managers work to mitigate behavioral and cognitive biases.

  • One study, looking at real brokerage accounts of individual investors, found that stocks with an unrealized gain are 50% more likely to be sold than stocks with an unrealized loss. For more information on this study, see “Are Investors Reluctant to Realize Their Losses?” from The Journal of Finance
  •  Another study found that when stocks are inherited, the disposition effect is half as large as it is when stocks are purchased by the investor. You can read more about this study in the Journal of Behavioral Decision Making
  •  Mark also discusses the use of stop-loss orders to reduce the disposition effect. This was studied in detail by researchers in the European Journal of Finance.

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Mark Riepe: Welcome to Financial Decoder— a new show about how cognitive and emotional biases can have a big impact on your financial life.

This is a companion to Schwab’s Choiceology podcast where we look at how the decisions we make impact our lives in general and the psychological forces that drive those decisions.

In this podcast we’ll decode the biases that influence specific financial decisions we all face. And we’ll also examine strategies designed to help us improve our decision making.

My name is Mark Riepe, and I’ll be your host.

As head of the Schwab Center for Financial Research, I have an up-close view of how biases impact the decisions of individual investors, and I continue to be intrigued by the power these hidden forces have over us.

To set the stage for today’s episode, I’d like to ask you to think about a simple task you probably do every month—looking at your brokerage statement and scanning the list of stocks you own. As you consider each one, you’re faced with a decision—does it make sense to continue to hold this particular stock, or should it be sold?

This decision generates some angst and lots of questions. And that’s a good thing, because each decision matters. Successful investors know that what to sell is just as important as what to buy.

But that decision of what to sell can lead to one of the most widely documented mistakes that investors make.

In fact, it’s so common that it even has a name—the disposition effect. We’re going to explore what the disposition effect is and the biases that cause investors to make such a common mistake.

The disposition effect is the tendency to sell your winners, stocks that have increased in value since you bought them, while holding on to your losers, those that have dropped in price.

An estimated 80% of individual investors in the U.S. who trade individual stocks exhibit this behavior, but Americans aren’t the only ones. Everywhere this behavior has been studied, the disposition effect has been observed. This means individual equity investors in Australia, China, Finland, France, Israel, Portugal, Sweden, Taiwan, and the U.K.—they all exhibit the same behavior.

Multiple biases contribute to this mistake, but I’m going to focus on the two that I find most compelling: loss aversion and mental accounting.

Let’s start with loss aversion.

If you’re like most people, a $1,000 loss hurts about twice as much as the positive feeling experienced from a $1,000 gain. This means you’re reluctant to turn an unrealized loss on a stock investment, also known as a paper loss, into a realized loss by selling it.

Selling magnifies the pain because realizing a loss is tantamount to admitting that you made a mistake. As long as the loss is only on paper, you can take comfort from hoping that the stock will bounce back. That hope vanishes once the loss is realized.

The second bias, mental accounting, comes into play when, in your mind, you create a separate little account for each and every position you own. In effect, you compute the profits and losses on a position-by-position basis and don’t pay attention to the fact that each of these positions is part of a broader portfolio.

The reason this can lead to an investing mistake is that you want your investing capital to be invested in the best opportunities. Mental accounting can blind you to the bigger picture.

The ultimate goal for most investors is to make sure their portfolio is generating the best return after taking into account an acceptable level of risk. If investors are too focused on individual positions, they lose sight of the fact that each dollar tied up in a poor stock means they miss out on an opportunity to put their money to work in a better stock.

So if we put these distinct biases together, what’s the impact in the real world?

One study, looking at real brokerage accounts of individual investors, found that stocks with an unrealized gain were 50% more likely to be sold than stocks with an unrealized loss.

Now that little factoid by itself doesn’t prove anything because the motivation for selling could have been that the prospects for the stocks sold were worse than the ones not sold.

But the study went further and looked at the performance of the stocks after they were sold compared to the performance of the stocks that weren’t sold.

And guess what happened? On average, over the following 12 months, the stocks that were sold, the winners in the portfolio, outperformed the stocks that were held, the losers, by 3.4%.

This study highlights one of the costs of the disposition effect. If your capital isn’t deployed efficiently you may miss out on better opportunities.

Investors in this example would’ve been better off holding onto the stocks they sold and selling the stocks they kept—the reverse of what they actually did.

This mistake is costly in another way. If your stocks are held in a taxable account, a reluctance to sell losing positions means you miss an opportunity to realize a loss and use that loss as a potential write-off to offset realized gains in the rest of your portfolio or other earned income.

The disposition effect has been found to exist among professional as well as individual investors, but empirical studies show that professionals are less susceptible to it.

And joining me now is a professional investor who is keenly aware of these biases and the havoc they can inflict on a portfolio. Omar Aguilar is the chief investment officer for equities at Charles Schwab Investment Management—CSIM for short.

So Omar, how do professional portfolio managers approach the sell decision, and what techniques are they employing that our listeners can employ when making their own sell decisions?

Omar: Thank you, Mark. At CSIM we have a lot of experience in dealing with behavioral anomalies. Behavioral finance is something that we experience on a daily basis. Even as professional money managers—portfolio managers, traders, analysts—they always deal with the same kind of decisions that most people have. Most of the biases that we feel with our portfolio managers and analysts and traders are the same biases that most people have—and that’s because we’re human. We all have exactly the same … we’re wired in a similar way, and therefore we are subject to the same human biases. So how do we deal with that? The way that we have dealt with that is by creating a framework that allows us to have a discipline so that we can mitigate most of the biases.

Let me be clear, those biases are things that are not going to go away; they are part of us being human. The only thing we can do is to try and find a way to try to mitigate those through a process that is disciplined. Now, the framework that we have created includes three steps. The first step is to establish clear investment objectives. The second step is trying to evaluate and assess what kind of risk we’re willing to take. And the last one is to try to find a process that allows us to implement those decisions and those objectives in a disciplined way—and I really want to emphasize the word discipline because that’s probably the best way that I can suggest that we in professional management allows us to mitigate most of our biases.

Mark: So you’re approaching this, I think, a little bit different than most individuals because you’re recognizing the biases right away. And when you set up your investment process, you’re putting in place a structure to mitigate those biases.

Omar: That is correct. So we’re trying to set up a framework that allows us—because we’re obviously dealing with the assets that represent a lot of people—we’re trying to understand how we can actually make sure that this is the most objective way for us to invest money in the market. So we obviously start by looking at the investment objective—what is this investment supposed to do? Is this investment objective something that we want to have for the long run, or is this something that is going to be for the short run? What kind of things do we need to do to make sure that we mitigate up front all those biases that we know we’re going to face?

Mark: So let’s talk a little bit about the investment objective process. What constitutes, in your mind, a clear investment objective?

Omar: Well, clear investment objectives start with the purpose of what we think this is going to be doing for the investor. And number one, what we try to do is look at the time horizon, looking at for how long are we trying to actually put this investment to work. And in many cases, the biggest component to this is how much risk are we willing to take to achieve those objectives. Typical investment objectives are we want to grow capital, typical investment objectives include, we want to generate income. Some of those could be a combination—we try to grow capital and at the same time generate income. In many other cases it could also be very defensive. It could actually be just to try to stay the course. So a lot of the investment objectives need to be clearly defined for the time horizon that we’re willing to have and at the same time trying to analyze the level of risk we’re willing to take to achieve those objectives.

Mark: So I think it sounds like, compared to most individuals, you have a much clearer identification process up front as to what the objectives are and how you’re going to be achieving those.

Omar: Correct.

Mark: Let’s talk a little bit about, then, risk assessment and budgeting. So how do you assess risk? How do you come up with your list of risks that you’re worried about?

Omar: And that’s actually the perfect question, Mark. Because, in many cases, you know, there’s a lot of discussion in the market, and there’s a lot of literature about risk and risk assessment and risk tolerance, and there’s a lot of people with questions trying to figure out what risk means. For us, in professional money management, it’s trying to understand what could go wrong. In many cases, this happens in everybody’s life, you’re trying to do something, no matter what it is, and at the end of the day you’re always thinking, “What could go wrong?” You know, it’s as simple as you buy a ticket to a plane. Well, you want to make sure you don’t miss the plane. You want to make sure you get to the airport on time. And you want to make sure that you get to the gate when you need to be there. You don’t want to miss the plane. You’re already trying to achieve a goal. Investment is the same piece. You try to understand up front what could go wrong and what risk you’re willing to take. There are certain people that really want to make it very close, they’re willing to go very close, by the time the gates are about to close, and they’re OK with that. There are other people that actually want to get there four hours in advance just because they really don’t want to take any risk. So for us, that’s what we call the sleeping point.

What that means is that is the point where you’re very comfortable knowing that you can sleep well at night. So if you don’t want to miss your flight, then you put your clock a little earlier. You want to make sure you sleep well knowing that you’re going to wake up on time so that you can get to the airport at the right time. If you are comfortable taking it a little closer, well maybe you put the clock a little bit more so that you can sleep more. That is really trying to understand how you can actually achieve those objectives. At the end of the day, what you don’t want to do is, you don’t want to miss your flight.

Mark: So in essence, in your process, you’ve listed out all the different risks, everything that could go wrong with the portfolio, and you’ve made a conscious decision to decide which of these I’m comfortable with, which of these things I’m not comfortable with, and then you’re adjusting your process accordingly.

Omar: Exactly. The big component to that is trying to understand how much risk are you willing to take in each one of those sources of risks.

Mark: So let’s talk a little bit about implementation and evaluation. What are you trying to accomplish with the disciplined process to approach this, because when you’re listing through your three main points, you really emphasized discipline. So why is that so important?

Omar: Discipline is the most important piece when it comes down to implementation, you know, regardless of what the investment objective is. You know, over many years of doing professional money management, what we have observed is that human biases usually tend to come out at times of stress. When the market is going up too high, when the market is actually crashing down, in many of those circumstances, usually that’s where human biases tend to come. If you’re risk averse, you’re usually not going to like it when the market goes down. If you really like to do herding, and you tend to be very biased toward your peers, you actually want to get into the market probably at the wrong time.

So a lot of those biases happen at the same time. So that same thing happens with traders. Traders actually tend to like to go and buy things when everybody’s buying it because they think they don’t want to lose track of being in the same place. So what we have developed is that creating a disciplined process that allows you to continue to follow a routine, so that you continue to execute the plan regardless of what happens in the market or with the volatility allows you to prevent you from your own biases. In many cases, if you have a plan, you talk to an advisor, you talk to yourself about things you’re going to do when things start to get a little bit risky. Then, you continue to execute the process in a disciplined way—that in the long run allows you to meet your objectives as you had planned.

Mark: So in essence you’ve created a situation where you have, in essence, a contingency plan for everything that could happen, and you have an approach—you’ve decided ahead of time with your team about how you’re going to handle that. So the idea of a spurious or emotional decision, that’s not really part of the equation anymore because that’s all been kind of thought out ahead of time.

Omar: Precisely. That’s the big component of trying to stay out of the biases of everybody and keep it objective.

Mark: Well, Omar, I’ve got to tell you that it’s actually enjoyable to hear that professionals have to grapple with the same issues just like individuals have to. Thanks for coming by today.

Omar: Thank you.

Mark: The goal of this episode is to help improve your decision making.

The good news is that you’re already on the right track by becoming aware of these biases, since you can’t fix what you don’t even know is broken.

But awareness isn’t enough.

So in addition to the decision-making framework that we heard about that professionals use, I have three other suggestions.

The first is to start fresh. Forget what’s already happened with each of your stocks and approach each one as if you’re looking at it for the first time. Think about its future prospects and the level of risk associated with it. How does that risk-reward tradeoff compare to other stocks that you don’t own? What are the taxes associated with selling? If the risk-reward tradeoff isn’t attractive after you take into account any tax-related costs, then selling makes sense.

There is evidence that the “fresh start” approach works. One study found that when stocks are inherited, the disposition effect is half as large as it is when stocks are purchased by the investor. Think about that. Investors are reluctant to sell at a loss when they made the call to buy it in the first place because they’ve got emotional skin in the game. When they inherit a stock, they’re more willing to cut the cord on a losing position because they’re approaching it with fresh eyes and have little or no emotional connection.

My second suggestion is to think about your next trade. Remember the earlier point about mental accounting?

You probably think about your gains or losses on a stock-by-stock basis. For example, I bought stock X at $100 per share, and I open a mental account just for that stock. If the current price is $90 per share, that’s a loss. I don’t like that, and I don’t sell to avoid recognizing the loss. But what if you broaden your mental account and evaluate gains or losses not on a trade-by-trade basis, but for a series of transactions? For example, I could sell that stock that’s down to $90 and immediately buy something else to replace it. By focusing my mental account on the original $100 investment, I’m able to move on from the sale in the middle where I took the loss and concentrate on how it’s invested now. It turns out that this way of thinking helps. Data from real brokerage accounts show that investors who sell and immediately reinvest the money show no sign of the disposition effect. Not only that, but when investors sell and immediately reinvest, they have better performance.

The third suggestion is to consider using stop-loss orders. A stop-loss order instructs your broker to automatically sell if the price falls to a certain point. For example, assume I buy a stock at $100 per share. I could place a stop-loss order at $90. That means if the stock falls to $90 it’ll be sold at the market price. Now, there’s no guarantee that you’ll actually get that price, but think of this as a commitment device to get out of a position that’s heading in the wrong direction. It doesn’t require you to make a decision when emotions might cloud your judgment. There’s real-world evidence that this can work. A study of real brokerage accounts in the U.K. showed that using stop-loss orders reduced the size of the disposition effect.

Those are the three tips, but I have one caveat.

Don’t walk away thinking that you need to sell a stock the minute it has a paper loss. But you should be aware that a massive amount of data indicates that a large majority of investors disproportionately sell their winners and not their losers. And they’re behaving this way primarily because they don’t like to admit they made a mistake. Recognizing a loss hurts, and fear of that pain can cause you to lose sight of the big picture.

So remember to give more consideration to the future prospects of your stocks and ignore whether they’re up or down unless it’s part of some tax-reduction or risk-based strategy.

And keep at it. As you gain experience, it gets easier to recognize your biases and adjust accordingly. One study, using actual accounts, found that the magnitude of the disposition effect for individual investors who had more experience was 75% smaller than it was for those who had less experience.

So the next time you review your stock holdings, make sure to look at both the winners and the losers—and don’t let biases stop you from doing what’s best for your portfolio.

If you’d like to learn more about these biases, I’d encourage you to listen to our sister podcast, Choiceology, where Katy Milkman shows how biases affect every sort of decision you might make in your life. You can find it at or wherever you get podcasts.

And if you’d like more insights into trading strategies, you can get answers to your questions, market news and commentary from Schwab’s experts at

Thanks for listening.

For more important disclosures, see the show notes and

Important Disclosures

Charles Schwab Investment Management, Inc., is an affiliate of Charles Schwab & Co., Inc.

The Schwab Center for Financial Research is a division of Charles Schwab & Co., Inc.

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The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.

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