Chapter 21
Cutting Your Losses
You read in Chapter 19 about the psychology of investing. That psychology once again comes into play when you have a stock that turns out not to be what you thought it would.
You did your homework, researched the company, crunched the numbers, and read up on the news, and thought you were picking a winner. Instead, the stock has been nothing more than a big disappointment and it’s dragging down your portfolio.
In this chapter, we’ll have a look at minimizing your losses, and at what it takes to get rid of an underperforming stock and find one that you’ll like. One thought before we get started: all investors make mistakes or suffer losses that are beyond their control. The important thing is to be able to recognize the mistakes and respond in a positive and productive manner.
Even Experts Make Mistakes
No one buys a stock that they don’t expect to succeed. That would just be counterintuitive to investing. Buying stock that drops in value, however, happens all the time. So what you need to focus on isn’t picking winners 100 percent of the time, but knowing when and how to react to losers.
During an interview in October 2010, legendary investor Warren Buffett candidly spoke of the biggest mistakes he’d ever made while investing. The biggest mistake, he said, was buying Berkshire Hathaway in 1965, which at the time was a struggling textile firm, not the hugely successful business that it is today. Buffet estimated that the acquisition ended up costing him and his investment firm shareholders billions of dollars over a period of time.
Other famous investors, including Victor Niederhoffer, Bill Gross, Monish Pabrai, and Seth Klarman, have also admitted to making major investing mistakes during interviews. The point is that even experts make mistakes when it comes to investing.
However, investors who know how and are willing to cut losses before they get out of hand are far more successful than those who deny the loss or decide to ride it out. Why is it so difficult, though, for many of us to admit we’ve made an investment mistake and get rid of it? Let’s look at some reasons why we tend to hold on to stock that’s lost value:
• False optimism. Investors holding stock that’s dropped in value tend to think that if they just hold on to it, it will regain its value and they will break even or realize a profit. The truth is, not all stock bounces back. Many stocks that have declined in value never regain past highs. Companies falter, and while some make spectacular recoveries, others go bankrupt. Some investors, despite repeated bad news and other indicators that a company is failing, hold on to stock solely on the irrational hope that it will somehow regain its value.
• Can’t admit a mistake. Many investors have held on to stock because they were reluctant or unable to admit they’d made a mistake. They hold on to a losing stock, rationalizing that it’s only a loss on paper if they don’t sell it, not a real loss. By avoiding the loss, they avoid the necessity of admitting a mistake.
• Sentimental attachment. Granddad worked for the railroad company his entire life and passed the stock he held in the company on to you. Now, the railroad company is on its way out, but you’re hanging on to the stock because Granddad gave it to you. Sentimental attachment to an investment is not productive, and Granddad would probably only be disappointed that you’re being investment foolish, not that you’re planning to sell his stock.
• Lose ability to take action. Have you ever had a disagreement with a friend, and you stop talking to each other? You fully intend to mend the rift, but things happen and time goes on, and it becomes harder and harder to address the situation and make amends. One day you realize that six months have passed, and you and your friend are still at odds. The same thing can happen with your investment portfolio. Investors often pay close attention to their portfolios when the market is good and they’re making money, only to put them aside and not want to deal with them when things are going poorly. Just like with the relationship, the longer you let it go, the harder it gets to address and fix the problems. Remember that small losses are easier to deal with than big ones.
• Tax concerns. Some investors put off selling low-cost stock because they’re reluctant to pay the taxes associated with the sale. In reality, they would be better off to get rid of the stock before it hits bottom, despite the tax consequences.
There are other reasons that investors are reluctant to cut their losses and ditch a losing stock, but these seem to be the most common. Know that it’s a common phenomenon, and many people participate in the denial game.
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Wall Street slang refers to funds invested in stock that isn’t going anywhere as dead money. It’s sitting there, taking up space in a portfolio, with little hope of it generating any income. Dead money, essentially, is useless.
Being Honest and Learning from Experience
The stock market can be compared to a huge experimental learning center, where investors learn as they go. That’s not to say that you ever want to start out ignorant, for, as you know, it’s vital to put in learning time before you start. No one, though, even experienced investors, fully understands every investing nuance, or can always accurately predict what the markets are going to do.
If you’re struggling in the market, take some time to assess what’s causing the problem. You can’t solve a problem if you don’t know the reason for it. Denying that there is a problem is dangerous business when dealing with your finances, as you then deny yourself the opportunity to address it and get it resolved.
Let’s take a look at some common sources of problems for investors, and what can be done to improve the situation.
Do You Understand the Companies You’re Invested In?
Investors often buy the stock of a company because everybody is talking about it, or they love the company’s product, or their friend made some money with it last year. None of those reasons, however, are good ones for buying stock. The only good reason to buy stock of a particular company is because you’ve researched the company and you’re convinced that it is fundamentally sound and you’ll profit from owning its stock.
If you don’t fully understand what the company does, how it’s structured, how long it’s been around, and other factors that affect its operations and finances, you can’t be sure of its fundamentals and strengths. You need to understand how the company makes its money, and then address factors that could affect its income. Is it highly susceptible to economic shifts? Has there been negative news lately regarding the company? You should understand not only the company in which your money is invested, but factors and situations that could affect the company, either negatively or positively.
TAKING STOCK
Get into the habit of reading and listening with a critical ear. Consider if the information you’re receiving might have an effect on a particular company, or an industry. When hearing about the massive BP oil spill, for instance, you might have instantly thought about how it would affect the fishing industry, and what the trickle-down effects might be.
If you own the stock and don’t fully understand the company, get started with learning more about it. Review Chapters 13 and 14 for a refresher course on learning about companies before investing.
Are You Making Informed Decisions?
There’s no shortage of information when it comes to choosing stock, but are you relying on information that helps you to make informed decisions, or getting caught up with the constant chatter present on television or the Internet?
How well informed are your decisions? They should be based on news from reputable sources, not obtained from blogs or from sources that are biased in some way, such as those promoting a particular product. Rely on company information, but make sure to balance it, as a company will present itself in a positive light as much as possible.
Review your portfolio and remember why you purchased a stock in the first place. Was the information you based your decision on sound? Are there still sound reasons for owning the stock? If not, remember that it’s by no means irreplaceable.
Are You Relying Too Much on Others’ Advice?
We all get busy and tend to look for shortcuts, one of which may be looking to others for advice regarding our investments. Seeking advice is not a bad thing, don’t get me wrong. Relying too much on advice from others without researching an investment on your own, however, is asking for trouble. Remember that you are ultimately responsible for your stock choices and for keeping up with what your stocks are doing.
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Research has shown that, consciously or unconsciously, many investors will buy popular stocks and then, if the value decreases, rationalize their loss by pointing out that many other investors also bought the stock.
You wouldn’t be reading this book if you weren’t interested in learning about stock investing and how to succeed in the market. Even if you work with a broker who recommends certain securities or actions, you need to have the knowledge to understand why he or she is recommending them and how they might fit into your overall portfolio. Asking for help when you need it is a great idea. Over-reliance on advice from others without doing the work you need to do on you own, however, is not.
Are You Paying Attention?
When you’re invested in the stock market, it’s a really good idea to pay attention not only to what’s happening with your accounts and the companies you’re invested in, but to what’s going on in the larger world.
Starting with your own accounts, you should be reviewing monthly statements, reconciling any discrepancies, and being vigilant for problems. If the market is volatile, sign up for e-mail alerts when the stock you own experiences a significant change in value.
Also pay attention to anything going on with the companies of which you own stock, and any factors that could affect the company. You read about the importance of top-down analysis when researching stocks, but it’s no less important when it comes to avoiding problems with your stock.
If you hear about a company experiencing big problems, don’t assume that those problems are confined to just one organization. When Bear Stearns collapsed in 2008, seasoned investors began to fear for the rest of the banking and securities trading industry, and with good reason. What occurs within one company, industry, or stock sector almost always has a ripple effect. If you can anticipate where those ripples are going, you’ll be able to be proactive in your trading decisions.
Review the fundamentals of the companies in which you own stock several times a year. If you don’t like what you see, stay on top of what’s going on within the company, the industry, and the larger economy, and then act accordingly.
Are You Behaving Patiently?
That patience is a virtue applies big time to investing in the stock market. To be successful, investors need to have patience when they buy a stock, while holding a stock, and when selling a stock. Snap decisions are beneficial in some situations, but rarely in stock market investing.
Some investors decide they want a particular stock and buy it, without setting an entry price or even bothering to check out its price history. They buy the stock at a too-high price, only to have the price fall a few days later. Before buying a stock, decide what your entry price will be, based on what you think the company is worth. Then you should be willing to wait patiently until the price reaches your entry point.
CRASH!
Day traders, in our opinion, cannot be considered “real” investors, partially because of their lack of patience. Nearly all very successful investors buy long-term investments, and understand that patience is critical to their success. If you think you’re more suited to day trading because you don’t have the patience required for investing, I’d consider you to be a speculator, which everyone knows is a very risky field.
When holding a stock, remember that its price can be affected because the company’s fundamentals have changed, or because of a market upturn or downturn. If you determine that the company is no longer a good investment, that’s one thing. But impatiently throwing off a stock that’s lost value due to overall market declines is quite another—and not a good decision. People buy and sell stock for all kinds of reasons, some of them sound and others not. Bouncing from one stock to the next because you lack the patience to ride out a downturn or you’re too anxious to wait to buy another one will not reward you in the long run.
When getting ready to trade a stock, ask if it’s reached the target price you set for the sale. If not, is there a reason you can’t be patient enough to wait for it to do so? If there’s a problem with the company that causes you to believe the stock will decline, it might make sense to get rid of it. Doing so because you’re unwilling to ride out a temporary price dip, however, is not a good idea.
Once you select a stock, based on thoroughly conducted research, plan to hold on to it unless there are obvious reasons for doing otherwise. Patience within the stock market is a rare commodity, but it really does pay off.
Going Easy on Yourself
A teacher who punishes a student for making a mistake isn’t a very good teacher. Instead, the teacher should explain to the student the reason for the mistake, and point her toward more information or other resources that can help her to correct the mistake, learning as she goes.
The same is true with investment mistakes. Accept that they’re going to occur, determine that you’ll figure out why they’ve occurred, and learn from them. If you’re making a lot of poor decisions regarding your investments, the most important thing is to figure out why that’s occurring. Maybe you need to find some help until you’ve got a bit more experience under your belt. If so, contact a financial advisor or see if your brokerage firm can provide advice. Remember that there are all types of advisors and brokers. Review Chapter 15 for a refresher course.
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Some researchers assert that investors who experience big losses in the stock market actually go through a grieving process, similar to that experienced following a death or divorce. Andrew W. Lo, a finance professor at Massachusetts Institute of Technology, said many investors will follow the traditional stages of grieving—denial, anger, bargaining, depression, and acceptance—following a significant investment loss.
Don’t take your mistakes too seriously or agonize about them. Look at them as learning opportunities and move on. If you can’t afford to make mistakes, you shouldn’t be invested in the stock market.
Getting Rid of the Dead Wood
Sometimes the only move that makes sense is to unload a stock. If you have a stock that’s performing poorly and you’re no longer convinced that it will be a winner in the long run, it makes no sense to hold on to it.
That’s not to say you should sell stock without doing your homework first. Know the total returns for each of your holdings, compare them to earnings of comparable investments, and draw your conclusions.
Some investors have all sort of criteria and reasons for buying stock, but none for when it comes to selling. You should establish reasons for which you’ll sell stock and follow through if any of those reasons occur. Here are some reasons you might want to sell stock:
• The stock becomes overvalued. If you bought a stock at $30 a share and it’s now valued at $60, the temptation is to hang on and wait for it to get to $90. If analysis tells you that the stock is overvalued, however, you’d do well to sell it off before the price starts to drop.
• There are fundamental changes within the company, such as it incurs high debt, has gone through three CEOs in less than two years, or launches a string of new products that fail.
• The reasons you bought the stock have changed. There were good reasons to invest in a home construction business when the housing market was booming. Once the bust occurred, however, those reasons no longer apply. Hopefully, you’ll stay on top of your portfolio and the news and circumstances that affect your investments and be able to anticipate when the reasons that you bought a stock no longer apply.
• You need to sell stock in order to buy other investments that you are convinced are better.
• You have a financial emergency and need to sell some stock to generate cash.
Because it’s difficult to know when to unload a stock, many investors rely on stop losses, which you read about in Chapter 16. Having a predetermined price at which you’ll sell the stock removes the burden of the decision, along with the emotion that can accompany selling a stock.
Selling stock at a loss or sometimes even at a gain can be difficult, but there are a couple of silver linings. If you’ve lost money on the stock, you get to realize capital losses to either help with the loss or offset overall capital gains. Make sure that you take advantage of all the tax benefits to which you’re entitled.
The other silver lining is the peace of mind you’ll encounter when you’ve finally gotten rid of the dead wood. We often spend time and energy worrying or feeling badly about something when what we really should do is act to change the situation. Holding on to a stock based solely on hope, or not wanting to admit you made a mistake, or inertia, is not a good strategy, and will not benefit your well-being—or your portfolio.
TAKING STOCK
Periodically review every stock you own. For each one, ask yourself, if you didn’t already own the stock, would you buy it? If you answer yes, stick with it. If there’s no way that, knowing what you know now, you’d buy that stock today, it’s time to get rid of it.
Anyone who invests in the stock market needs a strategy and the will to stay with that strategy. If you’re investing for growth, then you need to be prepared to hang in, even when it gets to be a wild ride. Succumbing to fear when conditions get tough and selling your assets takes you out of the game and eliminates your opportunity to profit when markets rebound.
You should write down your investment strategy and refer to it often, using it as your road map. Not only will this remind you of your goals and investment conditions, if you stick to your strategy, you will minimize the risk of acting based on emotion.
The Least You Need to Know
• If you’ve made some mistakes with your stock investments, you’re in good company; even experts make mistakes.
• The most important thing is that you learn from mistakes.
• Investors make mistakes for reasons that are easily avoidable.
• Selling stock can be difficult, but it’s important to know when it’s time to get rid of it.
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