How To Take a Bath in the Market
As investors’ positions tank, their attitudes begin to morph. What likely began as an enthusiastic purchase becomes an increasingly heavy burden. All the while, investors say prayers that are typically along the lines of “Please, God, just get me out even.”
If they must, investors can relinquish their initial optimism that they would make a killing, but actually witnessing their real funds evaporate is pure torture. But why is it so hard? It all comes down to the combination of emotions and irrationality.
Make me whole!
Ego is enemy No. 1. We all want to think of ourselves as being intelligent, and the dream is to have others see us in a similar light. Taking a bath in our portfolios forces us to acknowledge that we have made a mistake along the way, and it’s highly likely that the mistake is a significant one. From there, we enter the game of competing against millions of other investors in the world, and sometimes, unfortunately, we lose.
Other mistakes often arise from a misunderstanding regarding how investments work. The sunk cost fallacy bedevils both financial and business decisions. It even affects strategies with large-scale consequences, such as wars lost or lives sacrificed. The fallacy manifests as clinging to a losing course of action after having previously committed time, money or resources to it rather than admitting defeat and moving on to the next plan of action.
For instance, France and Britain continued to plow money into the Concorde supersonic airliner long after it became clear that the governments could not make up the high costs, low orders or insufficient number of passenger tickets sold. On a more personal note, have you ever overeaten at a buffet, not only because the groaning platters are tempting but also because you had already signed up for the cost? It’s the same idea, just in a different context.
Another deceptive belief, nicknamed the Monte Carlo fallacy or gambler’s fallacy, is the expectation that one event will affect the outcome of another when the two events are completely independent. We mistakenly think that a random event is more or less likely to occur depending on what has already happened.
For instance, if the roulette wheel landed on red one dozen times, is it more likely to fall on black now? The answer is no, seeing as the odds of the wheel landing on black versus red are 50-50, meaning it can still land on red just as frequently regardless of how often it lands on black.
Similarly, if a stock has been falling and falling and falling, it is no more likely to reverse course only to the break the pattern, although there may be other causes that result in this outcome.
Reasons to sell
You should never sell strictly because the price has gone down. Besides, growth and value investors may hold different views as to what a price decline represents in the first place. A value investor’s meat can be viewed as a growth investor’s poison. Furthermore, tax considerations should rarely be a sole consideration for taking a loss, notwithstanding the consolation of tax loss harvesting.
That said, an arguable reason in support of unloading may be a fundamental change in the security itself. Since the time of your purchase and the present time, the market share may have shrunk or the sales growth might have decelerated. Perhaps management has changed between then and now. Make some mental notes to guide your decision.
You can start by asking yourself the following questions:
- Why did you buy in the first place?
- Has the firm’s business model changed?
- How has the competition or the economic environment been altered?
Other considerations may also prompt you to sell. For instance, you may need to rebalance your portfolio as part of an ongoing discipline. Or you might need the cash so that you can pay your bills or make a purchase, such as affording new real estate.
While a predetermined exit strategy can work, try not to be too arbitrary. Every investor follows his or her own personal philosophy. Some may apply an automatic level, such as 10% or 15%, when it comes time to cut their losses, but one size will not fit all.
The percentage decline will vary in response to the time frame being contemplated as well. Selling out too quickly at too tight of a predetermined limit may subject you to whiplash, which is as painful to your portfolio as it would be to your neck.
For answers to additional questions regarding an appropriate selling strategy for your investment style, speak with your financial adviser today.