What do you do with a stock that falls below purchase price? Hang onto it or sell it?
Some would say buy more so that you can lower the average cost.
Others would say losers average losers, like the sign over hedge fund legend Paul Tudor Jones’ desk. He would say, “Don’t add to your losing position, get out.”
What do investors typically do?
[See: Avoid These 8 Rookie Investing Mistakes.]
Researchers find that individual investors tend to hold onto losers. They are far more likely to sell a winning stock than a losing stock. Well, holding onto losers could be a smart strategy if losers turn around to be winners.
But do they?
Turns out that is not the case. Research finds that those losing stocks investors hold perform worse on average than the winning stocks they sold. This happens when investors sell winners too early while holding onto losers for too long.
It’s easy to tell someone, “Hey, you should sell the losers and let the winners run.” However, following that suggestion is not as easy.
In psychology, there is a term called anchor point, which has a tremendous effect on the way we think and behave. Just think about the excitement you feel scooping up something you love at a 60 percent discount — the original price is your anchor point. In stock investing, we tend to perceive purchase price as an anchor point, and use it as a benchmark to make buy and sell decisions. Rationally, purchase cost is a sunk cost, meaning it is already paid no matter what, and therefore should not affect your decision now. Whether or not you should sell a stock should depend on your expectation of its future value, not the historical cost. Focusing on the historical purchase price steers your attention in the wrong direction.
There is another psychology term called loss aversion, meaning that we hate losses far more than we like gains of the same magnitude. And combining loss aversion with the anchoring point leads investors to behave very differently. We exhibit strong resistance to sell below the purchase cost because selling is associated with realizing losses, and the loss creates pain. To avoid the pain, we stick with the loser.
This is why some of the most successful investors attribute their success more to discipline than to intelligence. It takes self-discipline to fight human instincts.
For smart investors in training, how can we develop the self-disciplinary power to overcome this inherent psychological bias? It’s very hard to change the instinctive way of thinking so train yourself consciously toward the goal of higher rationality.
[See: 9 Psychological Biases That Hurt Investors.]
Train yourself to understand that not selling doesn’t stop the pain. Though you don’t have to incur the pain of loss now, holding onto loser stocks or doubling down may lead to even greater losses. So getting out to stop the losses is necessary for controlling your risk exposure. A related concept you need to learn: You shouldn’t expect every stock you own to turn a profit. Investment is a probability game; there will always be losses and gains. Your goal is to make sure the gains you make on some stocks exceed losses on other stocks. So learning to limit the losses on losing stocks is very, very important.
Try to forget about the anchoring point. Remind yourself, as a value investor, it’s the future that matters. For example, Under Armour’s (NYSE: UA, UAA) stock has fallen 50 percent in 2017 — should you continue to hold or even double down? A 50 percent drop shouldn’t be used to justify either a buy or sell. It would be too naïve to think after a 50 percent drop the stock must be cheap. The stock’s trailing P/E is still 32, much higher than Nike’s 21. On the other hand, should you sell? That depends on your judgment about the company’s future. Will the company reignite its growth from the overseas markets like it has in the U.S. over the past 20 years? Maybe. After all, Under Armour only has about 300 stores in China versus 8,000 Nike stores and 9,000 Adidas stores. With Chinese consumers spending more aggressively on sportswear, UA should have a good chance to succeed overseas.
Train yourself to think about other opportunities. When you hold on to losers and wait for a wishful bounce, you are actually wasting your money. That’s what economists called “opportunity costs” — the potential gains you can make from elsewhere. You need to understand perseverance is not necessarily a virtue in the stock market. Money is money. You don’t have to earn the money back on the same stock where you are experiencing losses.
Move on to other opportunities. There are plenty of stocks to choose from. Even if Under Armour has a chance doesn’t mean you have to stick to it now and wait for the uncertainties to resolve themselves. If you feel uncomfortable about the uncertainty, get out and move on to your next investment.
Investment is like gardening. You need to prune your shrubs and trees. Even Warren Buffett, the most well-known buy-and-hold investor in history, prunes his portfolio. Research finds that between 1980 and 2006, while Buffett on average held around 20 percent of stocks for more than two years, he sold about 30 percent of stocks within six months.
[See: 12 Tips for Investors in Their 50s and 60s.]
So prune your trees. Don’t be afraid to make the cut.
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3 Things to Do When Stocks Lose originally appeared on usnews.com
