Taking a loss is hard to take. But avoiding a loss can be much worse.
U.S. stocks have lost some $4 trillion since their peak in October 2007, but investors aren't fleeing the market en masse. So far this year, according to investment-research firm Morningstar, investors have taken $14 billion more out of U.S. stock mutual funds and exchange-traded funds than they have added. That is less than 0.4% of the total assets of U.S. stock funds.
In other words, while some investors have taken their losses, most are grimly sitting on them.
That could be a mistake. Research published in 1998 by behavioral-finance professor Terrance Odean of the University of California, Berkeley, showed that individual investors are 50% more likely to sell a winning stock than a loser—even though, on average, the stocks these investors sell go on to outperform while those they hold onto underperform.
Why the reluctance to bail? Selling an underwater asset, says Mr. Odean, "isn't primarily about economic loss, it's about emotional loss." Once you sell below your purchase price, he believes, you can no longer tell yourself, "I still made a good choice, and it'll come back."
Individual investors aren't the only ones who can't make peace with their losses, according to numerous academic studies. Mutual-fund managers who cling to losing stocks underperform, by roughly four percentage points annually, the managers who cut their losses.
On average, professional futures traders and stock traders hurt their returns by clinging to their losers. Real-estate investment trusts hang onto properties that are losing money longer than they keep those that are in the black.
Unpublished research presented at the annual meeting of the Society for Neuroeconomics earlier this month sheds new light on this old problem. Neuroeconomics is an emerging field that combines the techniques of neuroscience with theories from psychology and economics to study financial behavior.
In one study, led by Gregory Berns of Emory University, people lay inside a brain scanner while deciding to hold or sell an investment; the price of the asset changed randomly up or down. The researchers focused on the ventral striatum, a region of the brain that has been shown to respond to rewards, particularly when they are unexpected.
When an asset was underwater and its price rose, activity in the ventral striatum of the typical person in the experiment was "blunted," or insignificant, rather than robust. "Many of the participants told us they had hope for a rise," says Andrew Brooks, a co-author of the study. Perhaps because these people got what they expected, an uptick in price "wasn't surprising," Mr. Brooks says, and therefore didn't excite this part of the brain's reward center.
That suggests that many investors who are losing money may automatically assume—rightly or wrongly—that their position is bound to recover.
Other research at the meeting pointed to a second flaw in how investors might think about losses. A study led by Camelia Kuhnen of Northwestern University found that people are much worse at estimating whether a bad investment will produce mild or severe losses than they are at predicting whether a winning investment will generate small or large gains. "Learning [about probabilities] is particularly faulty," Prof. Kuhnen says, "when people are in a bad environment with losses left and right and they have their own money at stake."
There are several steps that can help you dump your losers.
First, get a second opinion, from a financial adviser or an investor you respect, on your money-losing positions. Ask not whether you should sell the investments, but rather if they are worth buying at today's price. If the answer is no, consider selling.
Measure how long you hold your losers and your winners. If you hang onto your money-losing positions much longer than your winners, then put yourself on a regular schedule of looking for losses to harvest. (You don't have to wait until December.)
Taking a loss is easier when you think of it as a swap—in which you replace a loser with a new investment in a similar (but not identical) asset—rather than a sale. That makes taking action easier, since you aren't forced to admit that your original judgment was a complete failure.
Finally, realize that a loser can change from a liability to an asset when you close it out at a loss, since you can use losses to offset up to $3,000 of ordinary income on your tax return.
"Think about the term 'harvesting your losses,'" suggests Meir Statman, a finance professor at Santa Clara University. "That should put you in mind of strolling in an orchard picking ripe peaches rather than rotten losses." Just be sure to check with your accountant to make sure the loss is worth taking.