How to Turn the Tables on The Disposition Effect

Good morning!

I hope this finds you well.

Welcome to another edition of The Matt Viera Newsletter.

The newsletter with the goal to inspire you to live the life you actually want to live.

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I am happy to announce this newsletter is officially a year old!

I posted the first article on October 1, 2022 (You can read that article here).

I have posted an article every week since then, with one exception (I may have been traveling then).

Thank you to those of you who have been with me since the beginning!

And welcome to those of you who’ve joined since.

I thank you all for your continuing support.

I hope all of you enjoy reading this newsletter as much as I enjoy writing articles to inspire you to live the life you actually want to live.

As this newsletter started as a discussion on personal finances, here’s an article discussing an investment situation I recently found myself in and how I plan to deal with it.

Here's a thought experiment for you:

I approach you on the street, hand you a brand-new, shiny silver dollar, and propose the following:

"Flip this coin. I'll give you $2000 of hard-cold cash if it lands on 'heads.' But…if it lands on 'tails,' you must pay me $1000."

Would you take the offer?

My guess is that more likely than not, you'd turn my offer down.

Why do I think that?

Most people (including myself) want to avoid realizing an immediate $1000 loss (especially with 50/50 odds).

That's definitely the risk you take when you gamble.

And while there's always a risk when it comes to investing, the risk of loss is typically realized after some time, if at all.

There are always exceptions to the rule, and I'm currently realizing a loss that, while not precisely immediate, is relatively severe.

I purchased shares in a REIT (Real Estate Investment Trust), currently down ~50%.

A ~50% loss of value over the course of less than a year.

This REIT is absolutely shattering the value of one slice of my investment portfolio.

Fortunately, I have a well-diversified investment portfolio.

In the grand scheme of things, my overall portfolio is up despite today's economic climate (and the loss of value of this REIT).

However, this particular REIT is like a sore thumb.

I'm on the fence about whether to cut my losses or continue holding on in the hope that the value of this REIT eventually increases.

Conventional thinking dictates I remove emotion from the equation as investing is a long-term game.

While I didn't think so when I purchased it, this REIT has become a relatively risky investment.

So, I ask myself daily: what do I do?

Do I hold or sell and take the loss?

I have to reflect on and apply what I learned to answer that question.

Early in my personal finance journey, I was on a quest to improve (and continuously improve) my financial literacy.

I took a class on investor psychology called "Behavioral Finance" offered by Duke University on Coursera.

One aspect of the class that stood out to me was learning about The Disposition Effect.

The Disposition Effect is the "tendency for individuals to be risk averse over gains, but risk seeking over losses."

In the context of investing, most people are inclined to sell winning investments to realize gains and hold onto assets falling in value in the hope that the price will increase above the purchased cost and can be sold without realizing a loss.

The professor argued, "When investing in the financial markets, we should try to reverse these tendencies."

Run gains (keep the winners) and cut losses (sell the losers).

I purchased the REIT at ~$11 per share. It's currently trading at ~$5 per share.

I'm holding on to the REIT, hoping that the price will eventually increase above $11, and I will sell it once and for all (I'm clearly under the spell of The Disposition Effect).

But the professor argues:

"You should be thinking about when to sell shares based on whether you believe the company will do better or worse in the future, not whether you will realize a gain or loss relative to the time you purchased the share."

I have no idea how to determine whether the REIT will perform better in the future (an investment analyst, I am not).

So, how do I turn the tables on The Disposition Effect?

If I sell and cut my losses, I can take advantage of what's known as Tax-Loss Harvesting.

Tax Loss Harvesting is generally defined as the "timely selling of securities at a loss to offset the amount of capital gains tax owed."

I took advantage of this last year when I expelled some losing stocks from my portfolio.

"An individual taxpayer can write off up to $3,000 in net losses annually."

So what am I going to do with this REIT?

My objective with investing is to play the long game and to take advantage of dollar-cost averaging.

The slice of my portfolo in which this REIT is in is relatively aggressive.

If it were down a few dollars, say ~$8-9, and if I were looking to retire in 20 years rather than 5, I’d definitely hold on to it.

But as it’s hovering at ~$5 per share, it’s a headache I don’t want to deal with.

I will keep my eye on the REIT through the end of December.

If it doesn't look promising, i.e., if the price is still hovering at ~$5 per share, I’ll cut my losses and sell.

Run gains and cut losses.

You can apply this to any and every aspect of your life.

The information provided is for information purposes only.

It is not intended to be financial, investment, or legal advice.

Interesting reads:

The Behavioral Finance course I took can be found here.

Want to learn more about Tax-Loss Harvesting? Click here.

Despite the risk of loss, click here to read why investing in the stock market is one of the best ways of building wealth “over the long haul.”

Thanks for reading!

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