The other day, while reading a book by the ‘undercover economist’ Tim Harford, I came across an example taken from poker of how people react to profits or losses. The author spent months studying poker, which, unlike most other card games, is elaborately organised at the highest level. He attended something called the World Series of poker in the gambling capital of the world, Las Vegas, and studied the techniques of what he calls ‘highly rational players’. One of them, Chris Ferguson, is a game theorist with a PhD and was world champion at the time.
Like any game or sport, poker can be analysed rationally, but in actual play, it’s a game where emotions and psychology play a big role. Players told Harford there are specific phases when players are the most prone to emotional surges that drive bad decision-making. Specifically, just after they had suffered a big loss. That’s the phase when they are most prone to making aggressive bets that are not well thought out. This also happens when they have missed out on some win that they should have landed but did not because of an error or oversight. In these situations, the right thing to do would be to acknowledge the loss and replan. However, what seems to happen is that players do not mentally accept the loss. They plan more aggressive and risky strategies in order to win back the money they feel is theirs by right. Obviously, now is the time to understand what is happening and make a correction.
Does this sound familiar in the world of investments? Of course it does. This is exactly what equity investors do. Every aspect of the behaviour is the same. Recognising a losing (or lost) situation and not trying to salvage it by trying to be heroic is a basic skill in investing. I find even mutual fund investors, who should have no element of gambling in their investing behaviour, are prone to this kind of thinking.
In fact, there’s generally a large blind spot in the investing mindset of even seasoned mutual fund investors, which is selling out of a fund. So much of the conversation around investing (and I plead guilty here) is about making the investments that getting out of investments is not something which many investors do well.
There are many reasons for selling funds, not all of them are good ones. There can be exceptions but the good reasons tend to be about the investor’s own finances and the wrong reasons tend to be about the fund. That may not be clear so I’ll explain. Overactive investors give three reasons for wanting to sell off a fund investment One, they’ve made profits; two, they’ve made losses and three, they’ve made neither profits nor losses. That sounds like a joke but isn’t. Someone will say, “Now that my investments have gone up, shouldn’t I book profits?” Alternatively, “This fund has lost a bit of money recently, shouldn’t I get out of it?” And finally, “The fund has neither gained nor lost, shouldn’t I sell it?” What I’m saying is that investors who have a bias for continuous action can create a logic for taking action out of any kind of situation. And which is the right reason for selling a fund? Obviously, none of the above. By themselves, they are not legitimate reasons for selling a fund.
So when should investors sell their funds? The right answer is they should be guided by their own financial goals. You should sell a fund when you need your money. The primarygoal of investing is not to invest but to sell because that’s when you achieve your goal. Be guided by that.