Behavioral finance studies have found that the average individual tends to be risk-averse. For example, behavioralists have found that to entice average people to accept placing bets, odds need to be in their favor.

Similarly, the field of behavioral finance has found individuals tend to feel the pain of a loss more intensely than the joy from a gain. Individuals tend to avoid admitting their investment errors, and the failure to admit such errors can lead to expensive mistakes.

One of the most common errors caused by the behavior known as "regret avoidance" is that investors continue to hold securities that have losses, feeling that as long as they don't sell, the loss is only theoretical, just a "paper" loss. For some, the act of selling is an admission that an error was made. This perception, plus the mental pain incurred when losses are realized, causes investors to be reluctant sellers.

A Different Way to View the Situation

How many times have you said to yourself, or heard others say the following: "I will sell as soon as the price gets back to what I paid for it."

The right strategy is that you should only continue to hold the asset if you would buy it today. In other words, what you paid for a security should have no bearing (except for the tax consideration) on whether you should continue to hold it. Ask yourself how the stock (or mutual fund) fits into your overall investment plan. If you didn't currently own any, would you buy it today? If your answers indicate the security wouldn't fit and you would not buy any, then you should sell immediately. The reason is simple: By owning the security you are effectively making a buy decision.

The same logic applies to load funds. You might be reluctant to sell load funds because you feel that the load would be wasted. Unfortunately, once the load has been paid, it becomes a "sunk cost" - gone whether you hold or sell. If you own a load fund, ask yourself whether you would buy the fund if it waived the load. If the answer is no, it would be prudent to sell.

Harvesting Losses

When you have an asset in a taxable account with a significant unrealized loss, you should consider the opportunity to sell and "harvest" the loss, especially if the loss is short term. Short-term losses are deductible at the higher ordinary income tax rate, instead of lower long-term capital gains rates. By realizing a loss, Uncle Sam shares some of your pain. If the asset with an unrealized loss still fits within your plan, consider these two options.

First, you can sell and repurchase the same security after 30 days, avoiding the "wash-sale" rule that would render the loss non-deductible. Second, swap the asset for a similar - but not substantially identical - security. For example, sell an S&P 500 Index fund and simultaneously buy a Russell 1000 Index fund as the two are relatively comparable. After 30 days have passed, you can reverse the swap.

Conclusion

You can prevent the paralysis induced by regret avoidance by remembering the following:

• Base buy and sell decisions on a long-term investment policy.
• Realize losses to obtain the tax benefit.
• Remain true to your original investment objectives.

This material is derived from sources believed to be reliable, but its accuracy and the opinions based thereon are not guaranteed. The articles and opinions in this publication are for general information only and are not intended to serve as specific financial, accounting or tax advice. Copyright © 2008, Buckingham Family of Financial Services. All rights reserved. This material may not be copied or distributed (electronically or otherwise) without the written consent of Buckingham Asset Management. The products or services described herein are available to US citizens and residents only and the information contained is intended for such persons only. No information contained herein is an offer to sell. Investors should read the prospectus of a security prior to making any investments. Please contact us if you have any questions at 314.725.0455.