What would you say is the hardest part of the investment game?
Finding new shares to buy? That’s easy. There’s tonnes of information out there, online and in print. How about actually buying them, then? Well, nowadays that’s as simple as a few clicks. But selling shares, on the other hand…
Selling we find very difficult. Most human beings will do almost anything to avoid taking a loss. That’s called ‘loss aversion’, and it’s a deep-rooted part of our psychological makeup.
Lance Armstrong put it like this: “I like to win, but more than anything, I can’t stand this idea of losing. Because to me, losing means death.”
And on top of a hardwired hatred of losing, it also takes us too long to admit we’ve made a mistake. By the time we’ve fallen out of love with a stock, chances are we’ve lost more than we should have.
If you back a spectacular winner, it often covers up plenty of your losers. But you can’t rely on constantly hitting the ball out of the park to get good returns. That’s not sustainable. Keeping any losses to a minimum should be a key part of your investing strategy.
That’s why in today’s Penny Sleuth, I’m going to take you through one tactic for doing it.
Selling at the right time is key – here’s why
Cutting your losers early is important for two main reasons:
1. The psychological benefit – It’s draining holding on to a losing stock. It saps the enthusiasm and optimism you need to seek out new ideas – and agonising over what to do will waste hours from your investment day.
Of course, as well as a distraction, it’s a constant reminder of the fallibility of investors!
2. The practical benefit - Bad stocks can crowd out the good. Put simply, if you hold on to your losers, they will absorb your precious savings. It’s what economists call an ‘opportunity cost’ – by clinging to the dud, you deprive yourself of the benefit from owning something better.
Think of it like gardening. If you let your weeds grow out of control, they take up space that should be used for new flowers. Just as gardens need brightening up with new blooms, so a portfolio benefits from the introduction of fresh stock ideas.
And until you weed out your losers, you can’t plant the next crop of winners.
Sounds simple enough. But it’s difficult to spot quickly which stocks are the weeds. Why? Well, unlike gardening, we planted these investment weeds ourselves! We fully expected them to bloom profitably.
So when things don’t progress as we hoped, there’s always a temptation to give it a bit longer. Maybe waiting another growing season or two will return our position to profit.
But a hope-based strategy is dangerous for an investor. To succeed, you need a more concrete plan.
Here’s what to do
The most ruthless way of dealing with your losers is to have a rigid stop-loss policy in place.
How? It’s simple. When you buy a stock, decide that you will sell it, no questions asked, if it ever drops to a certain price. Why? Because that removes any emotional element to the eventual sell decision, and avoids all the stress that can go with it.
Then, when you’re setting that certain price, do it with reference to the type of share and the market conditions.
So, 90p might be a sensible stop in a blue chip you’ve just paid 100p for. But if it’s a volatile mid-cap, or if the market is going through a choppy phase, an 80p stop might be more appropriate.
Set good stop losses and you’ll never have to worry about having a stock halve on you again. It’s a clean, simple approach with a lot to recommend it.
But bear in mind…
It’s not flawless, though. If the investment gods are against you, you could find yourself selling a dip, just before the big upward move you expected all along.
So another idea would be to set a price at which you force yourself to review a holding. This review should consist of one simple question – do I think the trend has changed?
Respect your gut instinct. More often than not you’ll be able to sense when something is going wrong with a stock. If it looks like the tide is turning, or the fundamentals seem less rosy, then it’s often best to take the hit and sell it.
Just like medicine, taking a loss might leave a nasty taste in your mouth, but it quickly fades, and your portfolio will soon be feeling better for it.