Have you ever had something taken from you? It tends to hurt more than not having the item in the first place. The sense of “mine” is powerful, and that feeling of ownership sets in quickly. It makes for a particularly painful experience when we lose what we have.
In the world of finance, you hear this expressed in the form of little rules of thumb or idioms.
-“I haven’t lost money until I sell.”
-“The stock was up before—it will get there again.”
For most of us, letting go is painful. It can mean admitting things to ourselves that sting, like admitting we made a mistake, or that we are not as competent or smart as we believed. The ego may not survive!
We see evidence of this when we look at investor biases. People have a habit of hanging on too long to underperforming investments, waiting for them to recover.
This is less common with diversified investments and more common when people own individual stocks or positions that are difficult to sell like some real estate investments.
I am not saying you should sell when an investment is down and divest completely (“get out of the market”). This can be one of the worst reactions to an investment downturn. However, occasionally we should recognize the best place for our invested money may no longer be within that investment. We may have a better opportunity presented elsewhere, and there is a “cost” to staying where we are and waiting for a stagnant stock to recover while something else might be growing. Sometimes it is better to take a loss, shake it off, and move on.
Learn from my mistakes: a little humility can go a long way.
A great example: let’s say we originally bought stock X for $90, it initially does well, and then the company hits a rough patch. Its share price drops from $100 to $65 a share. Many of us are conditioned to say “It will come back” or even “It’s gone on sale! Let’s buy additional shares!”
With individual stock positions, this is not necessarily true. There may be real reasons why the price has dropped beyond the emotion and speculation of other investors. The company may have lost key leadership, gained a legitimate competitor in their industry, run afoul of regulatory trouble, or stopped being innovative. The company could face too much debt, inventory that won’t sell, or an external event that disrupts its business (we can probably all imagine a recent disruption, right?).
We cannot be certain that an individual company will eventually recover. Those who tried to “ride it out” did not fare well with companies like Lehman Brothers, Enron, or WorldCom.
At the same time, emotion and speculation has gripped many stocks before, falsely shaking their prices before correcting over time. The “it will come back” mentality serves us well here. Most market shocks fall into this camp.
How do we approach this problem?
A key way to eliminate this risk is simple enough: avoid over-concentrating your wealth in a single company or industry. It is easier to trust the general march of human progress to improve after bad news than any single company. I would rather have one hundred potentially excellent companies in my pocket than a single potentially excellent company.
Of course, it cannot always be so simple. What if we are already invested in concentrated positions that have fallen in value? We see this most often when an employer gives their employees stock in the company. This is particularly popular in younger companies and the technology sector, where upper level management encourages employees to act like business owners, their livelihood wrapped inextricably with the fate of the company. We also see this in old inherited stock that is a large multiple of its original purchase price. How do we approach these scenarios?
The answer might be exciting, and it might be boring, and it might frustrate you, and it might just help you sleep at night: we make a plan. My clients and readers will likely recognize that 4-letter word. Like clockwork, everyone hears me go back to the plan or the strategy. It helps us make decisions when that stock you own goes haywire (or when things go well!). The plan serves as a lifeboat drill; we prepared for this possibility and know how to react.
Returning to where we started, losing what we thought we already had hurts. Many try to avoid “losing” in the finance world by sitting and waiting for things to get better, and this usually works. When it comes to individual companies, however, we have to have a plan for the case where things get bad (or really good!). We also have to, sting though it might, recognize when things have changed and we need to let go, even if it means admitting we were wrong.