Inside the Investor's Brain by Richard L. Peterson

Author:Richard L. Peterson
Language: eng
Format: epub
Publisher: Wiley
Published: 2011-01-04T16:00:00+00:00

A FATHER-SON STOCK SALE

Many factors influence who is susceptible to the disposition effect. An acquaintance of mine has been an executive at Cisco Systems since the early 1990s. When he started his job, he recommeded to his father that he buy some Cisco stock. His father made the purchase, and by late 1999 his stock was worth $7 million. The son had exercised his stock options in 1999, and he too had multimillion dollars in Cisco stock. One day they had an important conversation.

The father said, “Son, I’m going to sell that Cisco stock. Seven million dollars in the bank will change my lifestyle forever.”

The son said, “But Dad, if you hold on you’ll make even more money.”

“I’ve seen this happen before in Silicon Valley,” his dad replied, “and I don’t want to ride it down. With this money I can retire early and live the life I’ve always wanted. Thank you for the tip.”

His son was puzzled and a little angry. He told his father, “You’ll regret this decision. I know how great this company is.”

Of course the rest is history. The father now lives a relaxed and comfortable lifestyle, while his son is still working at Cisco. The son is by no means financially uncomfortable, but he still regrets holding on to all of his Cisco shares through the burst of the bubble.

Through the lens of the disposition effect, one could say that the father cut his winner short, and he only looks smart in hindsight. Further, one could say that the son held on to a loser too long. Of course, hindsight is 20/20. In this case, how can one differentiate between biased and sensible decision making?

The father recognized that the technology stocks were in an unsustainable bubble. He had specific plans for the profits, and he had achieved his financial goals. He bought when Cisco stock was selling cheaply, and now it was outrageously expensive. Every rally was seen as “gravy” (an unexpected but welcome addition). He understood that when one’s financial goal is achieved, and one does not expect significant further progress, it is time to change course.

His son, having less market experience, was unaware of the cyclical nature of booms and busts. He had no sense of fair value for Cisco stock. Based on his limited experience, he expected this bubble to make him ultra-rich if he only held on a little longer. For the son, every stock price rally was expected and declines were terrifying.

For both men, it was their perspective that determined how they felt about their wealth. For the father, once he surpassed his financial goals, and the stock began to look overvalued, he was looking to sell. The son expected gains into the foreseeable future, and he was dismayed by sideways or downward stock price action. When declines began, the son couldn’t rationally factor the changing market conditions. The son was paralyzed by his inability to accept the decline when it began. Rather than selling out with an enormous profit, his shares lost 90 percent of their value, and he held on all the way to the bottom.

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