Trend following is a methodology with a simple concept. Keeps (Buy) stocks that are going up, Exit (Sell) stocks that are going down. The tendency to sell winners too early and ride losers too long is referred to as the ‘disposition effect’.
But, why despite tons of evidence do we continue to do the same mistake? The reason I feel that we do what we do is because of pure Hope and Fear.
When a stock where we are long goes down, we “Hope” that it will come back to where we bought and hence it makes sense to wait. Those with a extra appetite for risk go on to average in the hope of getting their average price down and hence profit earlier itself.
When a stock goes up, we are more times than ever riddled with fear. We fear that the profit we are seeing may soon be washed away when market trends higher. After all, having seen that markets are cyclic, we tend to fear that a upcoming fall may wipe away all our profits. As the idiom goes, “1 bird in the hand is worth 2 in the bush”. Its nice to know that there maybe even more profit going forward, but since there is also a risk of losing the current profit, better to exit than wait is the thought.
The key reason for the above attitude by most investors is that they do not have a clue as to why they have bought the stock in the first place. Most of the time, it was based on a recommendation by some friend / television pundit or the broker. So, when it goes up, one is willing to take a profit as early as possible let the profit slip out of hand.
But the same attitude is not followed in loss since it pains once to take a loss. While its one thing to see a notional loss, once its booked, its becomes permanent. Hence, the best way to avoid the pain is by hoping that it will come back some day and wait it out.
In many of my blog posts, I have emphasized on having a plan, a strategy, a thought process before one enters into a investment / trade. Without it, you will never be able to judge whether the carbon your holding in your hand is Coal or Diamond.