The Hindu Business Line : Playing with words

Psychologists have shown that our reaction is dependent on how a situation is explained to us — positive words draw positive response while negative words have negative response. A friend who runs an investment boutique has understood this psychology well and has applied it to money management. How?

Assume the stock you purchased recently is running a loss. Chances are you will wait for the stock to move back to your purchase price before selling it. Two Israeli psychologists showed through intensive research that we tend to sit on our losses but take our profits quickly. They termed this behaviour as “loss aversion”.

Selling a loss-making asset

My friend is well aware that such behaviour can hurt investment portfolios. He, therefore, advises his clients to enter into “swap-assets”. It refers to replacing one asset (stock) for another. That is, selling the loss-making investment and buying another asset.

The difference is in way the process is explained. Selling a loss-making asset is painful. Selling the same asset to buy another one appears to give a different meaning. Clients cheat themselves by thinking that selling loss-making asset to buy another is like continuing to hold the original asset. Since they suffer from “loss aversion”, they are comfortable with swap-assets. The argument is the same as in roll-over of futures. Suppose you had bought July Nifty futures and were down 100 points on the contract. What would you do?

If you are a disciplined trader, you may close the position if your view differs from that of the market. If you are swayed by the strategies of your fellow-traders, you may roll-over the position. This is essentially selling the July contract and buying August. My friend’s swap-assets strategy is the similar.

He got the idea from US investment firms that popularised the loss-harvesting strategy. Harvesting is a positive word. Therefore, taking losses is made to look as a positive strategy! Indeed, word-plays are no longer the forte of marketing and advertising professionals.

(The author is a Chennai-based financial analyst.)

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