Most Common Investing Mistakes – Part 5 (Keeping Losers, Selling Winners)

The average investor often makes the mistake of holding on to their losers too long and selling their winners too soon. Let’s break this down to analyze each activity separately.

Investors hanging on to losers for too long

Investors tend to hold on to their losing investments for three reasons:

1) They view a paper loss as temporary and are still hoping for a turnaround.
2) They can’t stand the pain of locking in their loss.
3) They don’t want to admit they’ve made a mistake.

As investors see the price of their stocks decrease in value, they find it difficult to lock in the loss. There’s a voice in their head saying: “Hey, it’s okay. It’ll go back up some day. The stock price was high once so there’s no reason why it can’t get back there. I just need to ride it out.”

That’s only investor psychology at work. If we remove the psychology aspect as well as the emotional trauma of a financial loss, the picture would be very different and much clearer.

Let’s say you bought $10,000 worth of ABC Company at $50 per share and a year later, the stock price has dropped to $25. If you are a rational investor, you need to ask yourself the following question:

Has the stock price taken a nose dive because the fundamentals of the company have changed? In other words, has something at the core of the company or its industry changed so dramatically that it resulted in lowering the real value of the company (i.e. new competitors entering the market, an unfavorable shift in consumer behavior, negative demographic trends, etc.)?

If the answer is no (company still has a wide economic moat, consistent free cash flow, a strong brand, etc.), then patience is your best defense. Just because other investors are liquidating their stocks out of fear in the middle of a bear market or some other market panic, there’s no reason for you to sell.

However, if the answer is yes the fundamentals of the company have changed, then it’s time to sell the stock. There’s no point in hoping for a turnaround when the probability is low. No matter how painful it is to your bottom line and ego to sell at a loss, you need to make a rational decision.

The math doesn’t look good either. If your stock has dropped in price by 50%, it means that you need to get a return of 100% just to break even.

Investors in that situation often still think of the original amount they invested in the company as opposed to the current value of their holdings. This is important because you always need to look at alternatives when considering investment options.

With your stock now worth $5,000, you should imagine that this $5,000 is now in cash and available for you to invest as you wish. You have two options:

1) Invest it in the same ABC Company (which means you do not sell).
2) Invest it in another company that can get you a better return on your investment.

There’s nothing wrong with holding on to a stock if you truly believe it has been knocked down in price unfairly. This happens quite often when strong companies are taken down along with the rest during a recession as investors liquidate all their stocks and mutual fund equities out of fear and panic. In fact, when this happens, it may actually be a good time for you to buy more shares of your company at very low prices.

However, don’t make the mistake of holding on to a loser just because you’re hoping it will go back up in value or because it would be too painful to sell at a loss.

Just ask anyone who owns Nortel shares how they felt as the stock sank to zero. Actually, you don’t have to ask anyone; I’m not proud to admit it but I made that mistake and hung on to my Nortel shares too long.

Yes, I was hopeful that it could go back up; yes, I didn’t want to admit I made a mistake; yes, I couldn’t stand the thought of losing my initial investment. And no, it never occurred to me that Nortel’s fundamentals were deteriorating at an alarming rate.

Now I’m only hanging on to these Nortel shares as a reminder of the heavy price I paid for my irrational hope and inability to swallow my pride. I learned my lesson; it’s one costly mistake I will not repeat again.

Investors selling their winners too soon

Hanging on to losers too long can be explained by investor psychology but selling winners too soon is a different beast.

So why do investors sell their winners too soon? The answer can be summed up in one word: fear.

When investors buy a stock and it goes up in price, they often fear that the price will go back down so they want to lock-in their profit. And if by any chance they’re on the fence, all they need is a little push from the mainstream media.

How often did we hear throughout 2009 from the “experts” that the market had gone up too fast too soon and had outpaced the economic recovery?

How often did we hear from these same “experts” that a market correction of at least 10% was imminent?

The average investor who listens to these “experts” will also likely take their advice to “lock in their profit” or “take some money off the table”.

Investors who sold their winners in the middle of 2009 have missed out on tremendous additional gains as the market has marched higher into 2010.

So what should an investor do when they’re in the fortunate position where their stocks are worth more than the price they bought them at? When should they sell to lock in their profit?

The answer is simple. Only sell your stocks when they are fairly valued or better yet, overvalued. Selling anytime sooner simply means sharing your profits with the person who acquired your shares.

It’s as if you bought a valuable antique painting at a garage sale for $20. If this painting is by a famous painter and is worth $2,000 at an auction, why would you sell it to someone for $200? The only reason you would do that would be because you didn’t know the true value of the painting.

When it comes to investing in stocks, it’s no different. You need to be able to determine the intrinsic value of a company. That’s the bottom line.

Don’t make the costly mistake of selling your winners too soon out of fear of losing your profit or by listening to the “experts”.

If you take the time to learn about investing and always focus on the value of a company instead of its stock price, you won’t have to forgo any capital gains and share your profits.

In conclusion, to be a successful investor you need to do the complete opposite of hanging on to losers and selling winners even if it won’t feel natural and will definitely put you at odds with the crowd.

Selling your losers in a rational way will help you redeploy your capital toward a better investment opportunity. Letting your winners run will improve your investment returns many fold.

Be rational and humble instead of hopeful and proud. Accept your mistakes and learn from them instead of pretending they didn’t happen in order to protect your ego.

Related Posts:

Most Common Investing Mistakes - Part 6 (Emotions)
Most Common Investing Mistakes - Part 4 (Relying on Other People's Opinion)
Most Common Investing Mistakes - Part 3 (Focusing on Price Instead of Value)
Most Common Investing Mistakes - Part 2 (Following the Crowd)
Most Common Investing Mistakes - Part 1 (Overconfidence)