The Hindu Business Line : Profiting from emotions

CONSIDER this. You buy a stock for Rs 100 expecting it to move to Rs 150. Instead, the stock declines to Rs 60. What will you do? If you behave like how my friend did recently, you would keep the stock till it moves back to Rs 100 and then sell it!

Your behaviour goes against the basic principle of standard finance. Why?

Standard finance expects you to be rational. That is, if the stock declines, you are expected to sell it and buy another one. This is because holding on to your loss-making position is costly, as capital is unnecessarily locked up.

But you and I are not rational. We are driven by emotions. So, you tend to hold on to your loss-making positions because you hate making losses.

What will happen if the stock moves back to Rs 100? There will be many like you selling the shares at that level. The sharp increase in supply of shares at that level will pull down the price.

There could, however, be another force at work. If a stock has recovered from a low of Rs 60, it could be because of informed buying. These informed buyers would continue accumulating the stock, perhaps, because they expect it to move past Rs 100. The result?

After all of you have sold your shares at Rs 100, the supply comes down. If there is continual demand from informed buyers, the price will move past Rs 100. And as price moves above this major resistance level, more demand comes in, pushing the stock up sharply.

That is why it is not always advisable to sell loss-making positions at your initial purchase price, after holding the position all the way to its bottom.

(The author is Head, Research, Navia Markets)

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