Why we hold on to losses

Picture this. You have Rs 3 lakh of unrealised gains and Rs 1.75 lakh of unrealised losses on your equity trading portfolio. You can choose to set off the losses against the profits and still have Rs 1.25 lakh of net gains. Or you can choose to do nothing. As a third choice, you can take profits and hold on to your losses. Which would you prefer?

Cashing out

It turns out that you are more likely to take profits and hold on your losses. You are likely to turn risk averse when you carry unrealised gains. This means that you will want to take profits quickly, fearing that the market may wipe out these gains.

Interestingly, you do not behave this way with your loss-making positions. On the contrary, you become risk-seeking. The reason is simple. You do not like to take losses. So, you hold on to your loss-making positions hoping that prices will move up. This also has to do with regret aversion. What if you sell your loss-making position only to see the shares move up significantly thereafter? You would have not only lost the opportunity to make gains but actually ended up with losses.

And that is not all. You are likely to treat your loss-making positions independent of your profit-making positions. This essentially prevents you from setting off losses against gains. It is the same behaviour that you display when you take a high-interest loan, yet have money earning low-interest in your savings bank account.

The question is: What will you do with your gains? If you are a serious trader, you will most likely buy shares. Depending on your state of mind, you will buy shares that are part of your current loss-making portfolio. You will do this to reduce your average cost in the hope of recovering your capital. Or you may buy other shares that you expect to go up in the short term.

Urge to spend

But if you are not a serious trader, chances are you will delightfully spend the money, not the entire cash flow, but just the gain. Suppose you invested Rs 50,000 in a stock and sold it for Rs 75,000. You view the cash flow as two components — return of Rs 50,000 capital and gains of Rs 25,000. The capital of Rs 50,000 is your own money whereas Rs 25,000 comes from the market. You are, therefore, more inclined to use such money for buying products that you will not typically consider purchasing with your own money. Several use cash flow from trading gains to take their family on exotic vacations or buy fancy electronic gadgets. What will you do?

(The author is the founder of Navera Consulting. Feedback may be sent to > knowledge@thehindu.co.in )

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