Asymmetric Loss Aversion

People have an excessive aversion to loss. Gains are taken casually and yet people live with a crippling fear of losing money. A 50:50 bet is inherently balanced, your gain equals the amount you could lose, as do the odds, and yet few people will take such a bet, insisting on having a very much larger upside to justify taking the bet at all. People spend tax refunds frivolously, treating the money as a windfall, and yet watch in terror as their stocks lose the same amount or less, reaching for the phone to sell in panic at the very bottom of the market.

This is called asymmetric loss aversion, people fear the downside far more than they aim to achieve the upside. The result on our trading performance is obvious and profound, people live in denial as their stocks fall, refusing to realise a loss and holding on to the old piece of broker propaganda "it is never a loss until you sell", and yet the same people take stag profits on their gains, thus immediately selling out of whatever they have that is doing well. By not selling a losing stock, people don't have to confront their failures. If you don't sell out of a mistake, you forgo the opportunity to reinvest in something much better.

The tax system actually works in the favour of those who are willing to take their losses. You write off 100% of your loss and can carry this forward to offset against future capital gains. Later on you only report 50% of the capital gain as taxable income. If you buy $10,000 worth of stocks then their values fall to $5,000, if you still think this is a good purchase you should sell up and buy them back again. You will carry forward a $5,000 capital loss, then you buy them right back again at $5,000. Later on you may wish to sell something from your portfolio at a capital gain and this can be offset against the loss you have already accrued.

For the same reason that it is usually best to put off selling at a profit as long as possible so as not to crystallise any capital gains it makes sense to take losses early on. If you eventually sell the former loss making share you bought back at a profit you will have to pay a greater amount of capital gains tax then due to the lower cost base, but if you haven't already used the loss up against an earlier capital gain the loss will be netted against the gain and you will be no better or worse off than if you had held on for all those years. The "never sell at a loss" mentality that people have is stupid and irrational, from every perspective.

This is why people investing for retirement with a span of decades still invest a significant portion of the portfolio in bonds and cash. Although the chances of making a profit after inflation are next to nothing on that time scale, a great fear of short term volatility makes people put 40% or more of their superannuation into these non-growth investments.