One of the most enduring sayings on
Wall Street is "Cut your losses short and let your winners run." Sage
advice, but many investors still appear to do the opposite, selling stocks
after a small gain only to watch them head higher, or holding a stock with a
small loss, only to see it worsen.No one will deliberately buy a stock
they believe will go down in price and be worth less than what they paid for
it. However, buying stocks that drop in value is inherent to the nature of
investing. The objective, therefore, is not to avoid losses, but to minimize
the losses. Realizing a capital loss before it gets out of hand separates
successful investors from the rest. In this article, we'll help you stand out
from the crowd and show you how to identify when you should make your move.
Reasons Investors Hold
Stocks With Large Unrealized Losses
In spite of the logic for cutting losses short, many small investors are still
left holding the proverbial bag. They inevitably end up with a number of stock
positions with large unrealized capital losses. At best, it's "dead"
money; at worst, it drops further in value and never recovers. Typically,
investors believe that the reason they have so many large, unrealized losses is
because they bought the stock at the wrong time or it was a matter of bad luck.
Rarely do they believe it is because of their own behavioral biases.
Let's look at a few of these biases:
- Stocks Always Bounce Back - Don't They?
A glance at a long-term chart of any major stock index will see a line
that moves from the lower-left corner to the upper right. The stock
market, over any long time period, will always make new highs. Knowing
that the stock market will go higher, investors mistakenly assume that
their stocks will eventually bounce back. However, a stock index is made
up of successful companies. It is an index of winners. Those less
successful stocks may have been part of an index at one time, but if
they've dropped significantly in value, they will eventually be replaced
by more successful companies. The indexes are always being replenished by
dropping the losers and replacing them with winners. Looking at the major
indexes tends to overstate the resiliency of the average stock, which does
not necessarily bounce back. In fact, many companies never regain their
past highs and some go bankrupt.
Investors
Do Not Like Admitting They've Made a Mistake
By avoiding selling a stock at a loss, many investors do not have to admit to
themselves that they've made a judgment error. Under the false illusion that it
is not a loss until the stock is sold, they elect to continue to hold a losing
position. In doing so, they avoid the regret of a bad choice. After a stock
suffers a loss, many investors plan to hold onto it until it returns to its
purchase price. They intend to sell the stock once they recover this paper
loss. This means they will break even, and "erase" their mistake.
Unfortunately, many of these same stocks will continue to slide.
When stock portfolios are doing well, investors often tend to them like
well-maintained gardens. They show great interest in managing their investments
and harvesting the fruits of their labor. However, when their stocks are
holding steady or are dropping in value, especially for long time periods, many
investors lose interest. As a result, these well-maintained stock portfolios
start showing signs of neglect. Rather than weeding out the losers, many
investors do nothing at all. Inertia takes over and, instead of pruning their
losses, they often let them grow out of control.
Hope is the belief in the possibility of a positive outcome, even though there
is some evidence to the contrary. Hope is also one of the primary theological
virtues in various religious traditions. Although hope has its place in
theology, it does not belong in the cold hard reality of the stock market. In
spite of continuing bad news, investors will steadfastly hold onto their losing
stocks, based only on the faint hope that they will at least return to the
purchase price. The decision to hold is not based on rational analysis or a
well-thought-out strategy; and unfortunately, wishing and hoping that a stock
will go up does not make it happen.
. Realizing Capital Losses
Often you just have to bite the bullet and sell your stock at a loss before
those losses get bigger. The first thing to understand is that hope is not a
strategy. An investor has to have a logical reason to hold a losing position.
The second point is, what you paid for a stock is irrelevant to its future
direction. The stock will go up or down based on forces in the stock market,
the stock's underlying fundamentals and its future prospects.
Let's look at a few ways of assuring
a small loss does not become "dead" money or turn into a much larger
loss.
- Have an Investment Strategy
Having a written investment strategy with a set of rules both for buying
and selling stocks will provide the discipline to sell stocks before the
losses blossom. The strategy could be based on fundamental, technical or
quantitative factors.
- Have Reasons to Sell a Stock
An investor generally has quite a few reasons why he or she bought a stock, but
typically no set boundaries for when to sell it. Don't let this happen to you.
Set reasons to sell stocks, and sell them when these things occur. The reason
could be as simple as: "Sell if bad news is released about corporate
developments".
- Would You Buy the Stock Now?
On a regular basis, review every stock you hold and ask yourself the simple
question: "If I did not own this stock, would I buy it today?" If the
answer is a resounding "No", then it should be sold.
Tax-Loss Harvesting Strategies
A tax-loss harvesting strategy is used to realize capital losses on a regular
basis and provides some discipline against holding losing stocks for extended
time periods. To put your stock sales in a more positive light, remember that
you receive tax credits that can be used to offset taxes on your capital gains.
Conclusion
Taking corrective action before your losses worsen is always a good strategy.
In investing, avoiding losses entirely may not be possible; successful
investors accept this and try to minimize their losses rather than avoid them.
Selling a stock at a loss and receiving a tax credit is one benefit you will
receive. Selling these "dogs" has another advantage too - you will
not be reminded of your past mistake every time you look at your investment
statement.
