One of the hardest disciplines in investing is how to handle unrealized losses. These positions not only tie up capital that could be invested elsewhere, but they also can paralyze an investor. In its worst shape and form, this condition leads the focus on distractions, not on what’s generating the performance for the portfolio. This is a topic every investor should from time to time think about in order to improve personal investment skills and to avoid being drawn into a negative spiral.

Summary and key takeaways from today’s Weekly
– It is a mistake, however, commonly practiced to sell winning stocks too early while losers are being “averaged down”.
– I make a plea to either do it the other way around (upping winners) or if more conservative and moderate to pull the plug more quickly on losers.
– I call this “closing mind-fuck positions”. It gives you relief and liberation, not guilt.

I know that on various occasions in the past, I have already dealt with this topic, for example by taking a critical look back at some of my not-so-strong investments (see here, here and here).

I have never made a secret out of it that there will always be bad picks.

That’s simply part of the game and also part of the process to become a better investor.

Further, on a more meta level, I discussed the psychological aspect of keeping losses alive instead of realizing them (see here). From a different perspective, I discussed the pain of realized losses vs. gains one has never made (see here).

In a nutshell, the result is that besides the portfolio performing below potential due to capital being locked up in bad investments, the mental well-being of the investor is influenced negatively.

If not dealt with, both interact with each other and spin a wheel of negativity.

Up to a point where the focus is being redirected from the pulling horses to the ballast.

What I realized in my self-experiment about realized losses vs. missed opportunities is that I quickly forget about the losses. I leave them behind quickly. They don’t bother me any longer as soon as they leave my portfolio.

But what really hurts – even years later – are the winners that were sold too early.

Today, I want to remind my longer time readers and to educate my newer readers about this crucial subject. I am fully convinced that this topic should be put on the table from time to time because human psychology is a beast.

We need to invest without emotions. Our emotions shall not take control over our investment decisions. We need to keep cool.

This obviously does not only apply to buying decisions but maybe even more so to handling existing positions, especially unrealized losses.

To further elaborate on this topic, I am today adding the component of “negative compounding” which clearly needs to be considered in this context.

We are slowly getting closer – my ideas again closed the gap a bit. With my risks-first approach (paired with high upside), I am able to find stocks with great returns. I am convinced that it is just a matter of time until my ideas get the upper hand again.

Join me and my members on our journey to beat the markets!

^{both as per 27 November 2024 market close – since August 2022}

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Reverse or negative compounding – avoid it

The evergreen to destroy one’s personal stock portfolio performance is to cut the winners prematurely (without a strong fundamental reason) while rebalancing or cost-averaging down non-performing positions.

I know, I am going full-steam anti-mainstream again.

However, it is barely a secret that during one’s investing lifetime, there are maybe a handful of really strong picks with the potential to be life-changing. It is never the entire portfolio as a whole that brings strong returns.

Only a few picks, if held long enough, decide the fate of the portfolio, even making some bigger losses looking like a non-event.

Who cares about a position or two that are down by 50% when there’s a five-bagger or better pulling the average up massively.

A valid reason for me to sell a winner could be a too high valuation, a change of the CEO, the company entering diworsification through doing silly M&A, business momentum having turned negative, new competition, a lost patent or whatever reason that makes it hard to keep a stock based on its initial thesis. In short, the risk and reward must still be attractive.

The latter, averaging down is justified by lowering the initial purchase price and thus bringing down the break-even level – as if this were the goal of investing.

Personally, I hate this approach. Every time I hear about cost averaging being a great strategy, I can only shake my head. While in seldom cases I also still buy more at lower prices, most of the time – and it is my goal to become better at this in the future – I usually open a position once and leave it at that.

I need conviction based on probabilities and potential returns in relation to the risk I am taking on me. If I don’t have conviction, I am staying away. Then with time, an investment needs to be reassessed. How has it performed? Has something substantial changed? Is my initial thesis still valid? Yes? Good!

Either a position wins or it loses – and gets kicked out.

Peter Lynch famously described this approach by watering the flowers, not the weeds.

This is not exactly what I am doing and certainly not on a constant and perfect basis. Also, it is not what I am seeing necessarily to be the holy grail of investing. In the end, everybody needs to find a strategic approach that suits him or her best. You need to stomach your decisions.

With this, let’s discuss what to do with losers in the portfolio.

Starting with the obvious, mistakes whether in life in general or in investing in particular are common and unavoidable. Everybody makes mistakes. The core issue is not whether they happen, but when and what potential consequences could be.

In my intro, I briefly scratched the negative spiral. This is what I mean by saying negative or reverse compounding. What that is and why it is such an underestimated and toxic human behavior, the following example will make it clear.

Let’s assume we have found a stock and buy a position without doing too much due diligence and ignoring fundamentals. Maybe in the extreme, we do not even know what the business exactly is doing. Something with AI? Great! How’s it generating sales? No idea! But hey, everybody’s buying and the media are pounding the table, for Jim Cramer it’s a no-brainer – this is hot stuff and a sin not to be invested!

For whatever reason, the stock drops. The opposite of what we expected and intended to achieve with our investment. Whether it has been a falling knife we picked up or an over-valued stock doesn’t even matter. But we get nervous.

So, mistake number one was not enough research. It could also be bad luck. Let’s be more neutral here. If we realize at this stage that we were wrong, the consequential reaction would be to immediately quit and sell the position to clear up the mind.

No matter the loss or perseverance slogans to stay on board.

The loss would be limited and the mind as well as the remaining capital freed up.

What the majority do, however, is to make subsequent mistakes, initiating the reverse compounding snowball by loading up more. The average cost is brought down. The break-even a little less far off. Why is this negative or reverse compounding?

Well, by hoping to make back the lost money, we throw good money after bad, effectively making a small problem a bigger one. For whatever reason, a GameStop (ISIN: US36467W1099, Ticker: GME) moment could happen, making this a multi-bagger. This is not what happens very often, though.

Usually, a small loss turns into a bigger one, causing more frustration.

As if this loss weren’t enough by itself, this entire adventure is compounded by the opportunity cost – a concept Buffett has spoken about – meaning that the capital could and likely should’ve been invested somewhere else into a more promising case.

The correct way would be to gain the money back elsewhere – not by hoping that a mistake flips into fortune.

As said, I am by no means a master in this discipline myself.

What I can say and confirm, though, is that in most cases after I have parted with a loss-making position (the last one even just yesterday), I not only instantly felt better, even liberated. Freedom and relief, not guilt. I even have difficulties naming a case where I sold at a loss and then saw the stock going through the roof, being plagued with regrets till this day. Do you?

This happened when I sold a winner too early, though. But as far as I can remember not the other way around. Even if, it likely was immaterial, as I would have remembered it well which I don’t.

So, today’s message is to get familiar with this concept and to let it sink in.

By practicing it over time it should go easier by hand to make decisions that once were almost impossible to do. Become your own stock investment gardener – let the winners run and cut the losers (flowers and weeds).

What I have written in my paper notebook as a note is “cut mind-fuck positions”. I rewrite it every single week on the next page to have it always in front of me.

It is never easy and it won’t work out in 100% of cases. Mistakes will happen again, promised. But let’s learn from them and do what is more promising for great investment results, instead of sabotaging ourselves.

Limited damage is the soil for juicy returns.

Conclusion

It is a mistake, however, commonly practiced to sell winning stocks too early while losers are being “averaged down”.

I make a plea to either do it the other way around (upping winners) or if more conservative and moderate to pull the plug more quickly on losers.

I call this “closing mind-fuck positions”. It gives you relief and liberation, not guilt.

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