Investors tend to be much more willing to sell investments that have increased in value than those that have fallen. Psychologists even have a name for this kind of behavior: loss aversion. But being too eager to sell “winners” and too hesitant to sell “losers” can hurt your investment performance.
One problem with loss aversion is that it can distort your portfolio. Since investments with exposures to the same parts of the market often move up and down together, selling winners while holding losers can leave your portfolio overexposed in some areas and underexposed in others. That can reduce your diversification and inadvertently increase the amount of risk you’re taking.
Even if you manage to maintain a diversified portfolio, loss aversion could cause you to get rid of investments that are going to do well going forward and keep the ones that are going to do poorly. Stocks, for example, tend to have a “momentum effect,” meaning that the ones that have recently gone up are more likely to do well in the near future.
Loss aversion can also hurt when it comes to taxes (at least in taxable investment accounts). Since you don’t pay taxes on many investment gains until the investment is sold, being too eager to sell your winners can mean paying more taxes. And since in some cases selling investments at a loss can reduce your tax bill, being too hesitant to sell losers might mean higher taxes as well.
So how can you prevent loss aversion from harming your portfolio? It’s not always easy, but the key is to focus on what you ideally want your portfolio to look like. If a decision to sell an investment would bring you closer to that ideal portfolio, it’s probably worth doing. If it wouldn’t, you may be better off standing pat.