I’ve learnt several lessons in my lifetime as a stock market analyst and investor.
One of the most enduring of them has been – taking small losses is often better than taking small gains.
The sad part is that it took time for me to learn this important lesson.
I’d read it many times that investors must try to “cut their losses short and let their winners run”.
Sage advice, but I did not follow till about the fourth year of my career. So I was…
- Asking people to sell stocks after small gains only to watch them head higher, and
- Recommending stocks with small losses only to see them worsen.
You see, 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 fall in value is inherent to the nature of investing.
However what I’ve learned over the last few years is that the objective must not be 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 fact, people go bankrupt by not taking small losses.
See this chart. It shows how much your stock must rise to reach back the break-even point (your original cost), once it falls by 10%, 20%, and so on.
Data Source: Ace Equity
For instance, if you invest in a stock at Rs 100, and it falls to Rs 80 (or 20% loss), the stock must rise 25% for you to just get your original investment of Rs 100 back. Doable, right? This is also true when the stock falls by 30% and must rise back 43% for you to get your cost back.
But notice how the curve accelerates to the upside as your losses grow bigger. It’s like the magic of compounding, except working in exactly the opposite fashion!
If you lose 50% in a stock, you need to find a stock that doubles, just to break even! How often is it that you find a stock that doubles?
For an 80% loss, the gain needed to break even is 400%!
In short, the further it falls, the harder it is for you to get back you cost.
Now the question is – What stops investors from taking small losses and instead letting them grow into 10-headed monsters?
It’s human behaviour, dear investor!
In spite of the logic for cutting losses short (who doesn’t know that?), most investors are still left holding the proverbial bag.
They inevitably end up with a number of stocks with large unrealized capital losses.
At best, it’s ‘dead’ money. At worst, it drops further in value and never recovers – a permanent loss of capital…like you can see from this price chart of Prime Securities, a stock broking company.
Data Source: Ace Equity
Having seen a sharp rise in the stock price before the crisis hit in January 2008, and then a 10-20% decline, investors in this stock (and I know a few of them) believed that it will return to its highs in ‘some time’ like it did prior to the crash.
See what has happened to the stock thereafter. For those who had bought the stock at its January 2008 highs of around Rs 330, the stock must rise 2,290% from the current price to just cover up their costs. Hopeless!
Anyways, 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 behavioural biases, which is what the real reason is!
And what are those biases?
Let’s take a look at a few of them.
1. “I know markets always bounce back in the long term, and so will this stock.”
If you see the BSE-Sensex chart for the past few years, you can see a line that moves from the lower left hand corner, to the upper right.
This is true to the belief that most investors have that stock markets will ‘always’ make new highs over any long period of time.
However, this belief can prove to be very dangerous when it comes to individual stocks.
Knowing that the stock market will go higher, investors mistakenly assume that their stocks will also eventually bounce back after a crash.
However, it is important to remember that a stock index like the Sensex is made up of large, well-known companies. Ironical it may sound, but it is only made up of stocks that have been winners in the past.
The less successful stocks (like Satyam or Reliance Power) may have been part of index at one time, but if they’ve dropped significantly in value, they will eventually be replaced by more successful companies.
So the Sensex isn’t the true indicator of Indian stock markets. It is just an indicator of the past winners, and thus represents more of a ‘happy’ picture (and thus, a ‘dirty’ picture :-)) for an investor.
As such, looking at just the Sensex and then believing that all stocks you own will always go up in prices after a crash, is dangerous.
See this chart.
Data Source: Ace Equity
In fact, many companies never regain their past highs and some go bankrupt!
2. “I can’t believe I made a mistake!”
It’s human nature. Investors, in their true human spirit, do not like admitting they’ve made a mistake.
By avoiding selling a stock at a loss, many investors do not admit to themselves that they’ve made an error in judgment.
Under the illusion that it is not a loss until the stock is sold, they choose 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 thus ‘erase’ their mistake. Unfortunately many of these stocks will continue to slide.
3. “I don’t care because I believe it will come back again!”
When markets are doing well and you are seeing profits everywhere, it’s easy to disregard 1-2 stocks that may be falling in price.
What this leads you to is sheer neglect of the losing stocks. And this subsequently results in an otherwise well-maintained portfolio to start showing signs of neglect.
Rather than cutting out the losers, many investors do nothing at all. Disinterest takes over and, instead of pruning their losses, they often let them grow out of control.
4. “I’m always hopeful!”
“Always be hopeful of the future,” taught my grandma.
Hope is the belief in the possibility of a positive outcome. This is despite the fact that there is some evidence to the contrary.
In spite of continuing bad news, investors will steadfastly hold onto their losing stocks, based only on the ‘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.
Unfortunately, ‘hoping’ that a stock will go up does not make it happen. You know it, don’t you?
Our brain is a leaking boat
The brain we have on the top of our head isn’t a flawless machine. It is definitely powerful, but it has its weaknesses. In everyday terms, we call such weaknesses as ‘biases’.
The good part is that while we cannot exchange our brains with other people nor can we upgrade it at a hardware shop, we can avoid mistakes that our biases cause by just taking notice of them.
Like if you are in getting into a boat, you would probably want to know about any holes in it before you start paddling. Right?
Biases are such holes in our reasoning abilities and they can impair our decision making.
Simply noticing these holes isn’t enough. A boat will fill with water whether you are aware of a hole or not. But if you are aware of the holes, you can devise methods to patch them up.
In the same way, if you know how your biases (or faulty brain wiring) can hurt you, you will take precautionary action to safeguard yourself from them.
Like I realized the importance of taking small losses and avoiding them from growing into 10-headed monsters.
Now it’s your turn!