28 April 2023

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Emotionality and irrationality: which investment to liquidate

Luigi Campopiano

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Sometimes you may need liquidity to meet a large, unexpected expense. If the current account is insufficient, you must liquidate one of your investments to recover the necessary money. But which investment should you "sacrifice" among the various ones in your portfolio? 

Behavioral finance, or research on the behavior of investors, teaches us how decisions are often made through mental shortcuts. These cognitive biases help to decipher reality based on what has already happened to act more quickly. The biases, precisely because they are weighted by careful analysis, are often not rational and therefore make us fall into an error. 

Faced with an investment to be liquidated, the investor will not liquidate the rationally more convenient one, but the one with the least impact. According to what has been statistically studied by behavioral finance, between two solutions, most investors will liquidate the solution that has a positive sign, even if it has made gains compared to the negative solution. 

Most likely, the upward trend of the liquidated solution will continue, while the losing one could go down again and, even if it reverses its trend and starts to rise, it may not gain as much as the positive solution. 

This phenomenon is the disposition effect and the attitude of prematurely liquidating a winning solution and not selling a solution in time that has depreciated. This occurs for a purely emotional cause. Excessive emotionality in finance is a source of trouble: the solution is sold for profit because the investor realizes an immediate gain, which causes satisfaction and pride. While selling the solution that has lost value, the investor realizes a loss of money, which generates regret. The investor acknowledges a mistake has been made. 

At the same time, a little bit of fear and hope also takes over. Still, irrationally, the investor feels a fear of losing what they have already gained with the first solution. If it has grown for so long, maybe sooner or later, it will go down and lose value. This is why the investor prefers to freeze the gain obtained rather than live in the uncertainty of the next market fluctuation. 

The investor, even if they rationally know that stock could still go up and earn money, is more frightened that they could lose what has already been collected or banked. With the second solution, the opposite occurs: having lost value is a fact of suffering and the investor deceives themself with the false hope that the solution will increase again sooner or later.

This irrational hope has the function of not making the investor face the loss of value recorded so far and of postponing its acceptance. The later you sell a lost stock, you will regret the loss. Between the large loss of money and the relative share of the gain, due to the disposition effect, the gain wins, and the sale of the loss-making stock is postponed. 

Is it always right to keep the growing solution and sell the one at a loss? 

It depends on the context. However, behavioral finance wants to underline that the bias of the disposition effect does not allow the investor to analyze and understand the current market's real dynamics and make a rational decision. 

Selling the winning solution is done on impulse. The right thing to do is to try to keep a calm and lucid mind and put emotion aside. In this case, the advice of an expert is essential because anyone who works in the stock and financial market can illustrate well what is happening and, even if nobody has the magic wand, it can help to rationally evaluate the different choice options so that the investor acts most profitably for their portfolio.