I met a gentleman (a friend’s brother) recently who owns 45+ stocks in his portfolio, most of which are bad businesses – he realizes that – and are deep into losses despite the decent run in the stock market over the last few years.
“What should I do with these stocks?” he asked me. And he is not the only one who’s asked me this question in the past. I have met numerous people over the past few years who have held on to bad businesses and losing stocks in their portfolios, and not knowing what to do with them.
One way people look at such stocks is – “Oh, this XYZ stock is already in a deep loss. What would I get by selling it anyways?”
Another way is – “I will sell this ABC losing stock only when I get my capital back. I don’t mind holding it for the long run.”
Well, this second thought is what creates a lot of “forced” long term investors – people who stay invested in a bad stock for the long term because they don’t think they have an option to sell it.
Nobody Likes Losing
That’s true! So why do people hang on to losing investments?
Because selling feels even worse.
The pain of a loss is substantially greater than the pleasure from a gain, researchers of investment behaviour have found.
People will go to great lengths to avoid pain. Accordingly, our inclination when facing a financial loss is to convince ourselves that the asset is going to bounce back and we will at least break even.
“It’s only a paper loss,” people would tell themselves. “It’s not a real loss until I sell.”
Anyways, one suggestion I gave to my friend’s brother was to hold on to businesses he knows are “obviously” good, and sell the ones he knows are “obviously” bad, irrespective of what those stocks have done in the past.
“Your cost price does not matter when you are looking to decide what to do with a stock in your portfolio,” I told him. “What matters is today’s stock price – assuming it’s a good business and you are looking to buy that stock afresh today – and your expected returns from it over the next 10 years.”
If you wouldn’t buy more of a stock today on which you have a loss, sell it. Don’t wait to “get even.” Chances are there are better ways to invest your money.
No well-managed store keeps obsolete goods in inventory; neither should you keep losers in your investment portfolio.
And if you think “How much more can it fall from here on?”, please note that every 90% loss begins with a 10% loss, and then goes to 20%, then 30% and so on. So, when you realize you’ve made a mistake in the matter of stock selection, it’s better to take the loss sooner, not later.
In his Owner’s Manual, distributed to Berkshire Hathaway shareholders in 1999, Warren Buffett wrote –
Do not think of yourself as merely owning a piece of paper whose price wiggles around daily and that is a candidate for sale when some economic or political event makes you nervous. We hope you instead visualize yourself as a part owner of a business that you expect to stay with indefinitely, much as you might if you owned a farm or apartment house in partnership with members of your family.
Now, “indefinitely” is a long time. Although Buffett was talking about his own company, Berkshire Hathaway, his advice applies to any well-run company. With regard to Berkshire‘s portfolio of companies, he noted in his 1996 letter to shareholders that…
We continue to make more money when snoring than when active. … [Y]ou simply want to acquire, at a sensible price, a business with excellent economics and able, honest management. Thereafter, you need only monitor whether these qualities are being preserved.
The last sentence gives us the first clue about when to sell: if the company no longer provides “excellent economics” or is no longer run by “able, honest management.” Thus, if your original investment thesis is no longer valid, consider getting out regardless of the stock price.
Time and time again, investors take profits by selling their appreciated investments (“Oh, what if I lose my gains!”), but they hold on to stocks that have declined in the hope of a rebound (“I want to get my money back!”).
If you don’t know when it’s time to let go of hopeless stocks, you can, in the worst-case scenario, see the stock sink to the point where it is almost worthless – a permanent loss of capital.
There is no guarantee that a stock will bounce back after a long decline. While it’s important not to underestimate good stocks, it’s equally important to be realistic about investments that are performing badly (because the underlying business is bad).
Recognizing your losers is hard because it’s also an acknowledgment of your mistake. But it’s important to do that sooner than later.
Don’t be afraid to swallow your pride and move on before your losses become even greater.
“And then,” as I advised my friend’s brother, “Start with a clean slate, and this time, please do it sensibly.”