Cutting the Flowers and Watering the Weeds

Individual investors typically perform poorly when managing their own investment portfolios.  This is evident in numerous studies in which individual investors collectively perform far worse than market index benchmarks such as the S & P 500.  Prospect theory plays a huge role in investor psychology and behavioral finance.

The prospect theory value function shows that people are generally risk adverse and that losses hurt far more than gains (generally twice as much).   An example of this from an investment standpoint is that investors hold onto their losses for too long and sell their winners too quickly.  They lock in their gains for a winning stock while hoping for a losing stock to recover.  To make matters worse, individual investors will often buy more of a losing stock by rationalizing that buying more is an even better deal.  These tendencies that individual investors have has been described by Peter Lynch as “cutting the flowers and watering the weeds.”

Investors’ rationale for holding onto losers is that by selling, they will actually become losers.  This implies that investors feel that ‘the game is not over’ until they sell the underlying security.  This makes little logical sense because financial markets are liquid and the current prices reflect what another investor would pay.  This means that if the market price is less than the purchase price, the position is already a loss. 

The price that one pays as an investor should be considered a sunk cost and the price paid should never be used as a reference point.  Instead, you should re-evaluate and judge the security in terms of its value and potential based on the current price.  In most situations, individual investors would be better off if they sell their losses and let the winners run.  

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