Sooner or later, everyone will discover that an investment did not work out as originally expected. Such losing positions in your portfolio not only affect your overall performance. What can have even worse consequences is the psychological effect these positions have on you as an investor. I also discuss one personal misinvestment of this year.
If you ask an investor whether he or she has ever had a losing position in the stock portfolio, the obvious answer will be “yes, of course”.
Should the answer be “no, I am always right” – well, stop the conversation. Everyone investing money in stocks from time to time will make mistakes. There will always be positions that did not work out as originally expected.
As Peter Lynch said:
In this business if you’re good, you’re right six times out of ten. You’re never going to be right nine times out of ten.
Quotefancy, (see here)
But what ultimately separates the weeds from the crop is how a successful investor handles such positions.
One option is to stick with it and ride out the weak performance. Hope for the best and stay strong.
However, the other option is to finally face the truth and cut your losses consequently. What sounds counterintuitive at first glance and will certainly be painful for many in the beginning, might actually be the better alternative.
Being active in the markets for more than ten years now, I have tried both.
Finally, I personally abandoned the “buy-and-hope-and-pray-strategy”. Not only do these losing positions drag on the overall performance by not turning back up. In fact, most turnarounds don’t turn. They even drag on you as an investor.
Why this is the case, how to overcome this obstacle and how to grow as an investor in this regard, is the topic of today’s Weekly.
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The motive for holding on to losing positions
One of the first “tips” beginners get from more experienced market participants is to sit out any losses, because over the long-term one will make money – or not lose, as they say (not losing any money, however, is not the same as earning it).
Just stay strong and overcome your fears. You will be rewarded, finally! The longer the investment horizon (the time you will not touch your investments), the higher the chances to succeed.
This is the theory that motivates many people to stay strong and hold on to their losing positions.
But first, it can’t be applied by everyone. Not every investor has the same amount of time to ride out losses. Imagine you are 60 years old. Do you want to wait 15 or 20 years to break even (or not) on your losing positions? Many losers even never come back! Not to mention how you will feel during this waiting period as the losses drag on your nerves.
And second, you are at risk of sinking even more money when practicing another well misunderstood “advice”. If you try to average down and put more money into your losing position, you must stand deep in faith and know what you are doing.
I am not condemning averaging down in general. Quite the opposite. It is often the right thing to do, in case you checked the fundamentals of the underlying business before you invested your first tranche. You should only average down with confidence, not in hope only.
My point is, you must have valid reasons for doing so. If your original investment thesis is still unchanged, there is no reason for not buying more shares. But you should not do so blindly and just out of pure hope for the better!
As my readers probably would expect from me – though being a person of faith – I am rational in this regard, not emotional. And this is one of the topics where I want to bring clarity and make a clean sweep to help those that read this article until the end.
There will always be more emotional believers than serious investors in the markets, however. But that’s where our chances are! Unfortunately, many people acting like this, do not know what they are doing. They are just hoping for the best – their misinvestments finally to turn.
However, hope or faith are no valid investment strategies! They are just emotions that drag on your nerves and stop you from making decisions that will ultimately free up your mind – and your capital!
Not surprisingly, the reasons for such behavior are of psychological nature. In my Weekly about the “hidden risks of ETF investing”, I already touched on this topic.
The key words in this regard were “loss-aversion” and “risk-aversion”. It is important to understand the difference between the two and how psychology holds many investors back from taking rational decisions.
I wrote:
But be careful, loss-averse is not the same as risk-averse!
Interestingly, many people are loss-averse, but not risk-averse. They:
– prefer a sure gain over a speculative and unsure gamble to the upside, hence prefer cutting winners and taking money of the table prematurely– but seek to avoid sure losses (or limiting losses) in favor of gambling in the loss frame, hence are risk seeking and hope to flip the loss into at least a zero
Hidden risks of ETF investing (see here)
[…]
Approaching the above with common sense and logic, you would say that it should be expected the other way around. Especially when it gets to investing money in the stock market.
The answer I had for this irrational behavior was the fear of having to admit that one did a mistake by taking losses.
That’s why many prefer the rotten apple over the juicy one.
Recommendations like “only a realized loss is a real loss” or “as long as I don’t sell, I don’t have a loss” are not only misleading, but very dangerous. For your investment success, but also for your mindset!
It is amateurish language.
Hence, let’s dive deeper into this topic for a mindset-shift.
The problem with holding losers in your portfolio
Very obviously, holding on to a losing position ties your capital and hinders you from doing a different investment with this capital position. You can only place your bet once.
This leads us to the problem of “opportunity costs” that I never hear from non-professional investors. They just “invest for the long-term” – in pure believe, but seldom with fundamentally strong reasoning.
I found a very good definition on the page of the Corporate Finance Institute that I do not want to rewrite in other words. Here is the quote form their site:
Opportunity cost is one of the key concepts in the study of economics and is prevalent throughout various decision-making processes. The opportunity cost is the value of the next best alternative foregone. In simplified terms, it is the cost of what else one could have chosen to do.
Corporate Finance Institute, (see here)
Applied to stock investing and in even simpler terms (in my words): If there is a better place (stock) to put your money into, then do it!
It would be very foolish not to do so and very irrational. But psychology is holding those back who do not want to face the truth and admit they made a mistake.
It is not a sign of strength to hold onto a failed investment and maybe even load up more. You show real strength by admitting that you were wrong and are willing to learn from the mistake(s) you made.
The other thing is self-deception.
Of course, you have to differentiate between an overall market decline like the current correction of 2022 where many stocks fall (but not all!) and an individual stock price falling due to whatever reason (and decoupled from overall market movements).
Hence, always have a firm investment thesis.
You should always be able to explain in easy words and few sentences, why you made a certain investment. If you are not able to do so, you are very likely not knowing what you are doing and only hoping.
I do not write this to attack some people. Furthermore, I want to help those that could get into trouble making the right decision when under pressure due to declining prices and upcoming emotions. The deeper the drawdowns, the heavier the pressure usually is. If you prepared accordingly, you can keep a cool head and act in your best self-interest.
If you found a better opportunity for your capital to appreciate, better change horses in most cases.
Besides deploying your money into a more promising, likely higher return option, you are doing another important thing: You free up your mind!
This much underestimated effect is only understood, when experienced. You cannot understand this without having tried out for yourself.
I can even give you a concrete example from one of my personal misinvestments of this year. Sometime during the spring, I bought shares of Bausch Health Companies (ISIN: CA0717341071, Ticker: BHC). BHC is a pharmaceutical company with many products and several divisions.
My investment thesis was a supposed-to-be undervaluation of the whole complex which should be closed with a spin-off of first one and later a second subsidiary.
I bought shares before the partial spin-off of its subsidiary Bausch+Lomb (ISIN: CA0717051076, Ticker: BLCO). Bausch+Lomb was the original holder of the RayBan brand which, however, was sold to Luxottica Group (now after a merger: EssilorLuxottica ISIN: FR0000121667, Ticker: EL) already more than 23 years ago.
Bausch+Lomb on its own should have been already worth more on a standalone basis than the whole pre-spin-off company including Bausch+Lomb! I thought the market would rerate BLCO and thus also its parent company BHC.
But what I underestimated was the heavy debt-load of the parent company and the overall bad market environment. Due to an acquisition-rich past, BHC has lots of debt on its balance sheet (currently more than 9x its equity value!). The spin-off only was done at the lower end of the estimated price range, hence BHC received less money.
All in all, the stock of BHC cratered by 50% in a few trading days.
What did I do? Did I buy more in hope for a turnaround the market in the short timeframe did not want to acknowledge? No, the opposite.
I sold my entire stake, finished this failed chapter and freed up my capital – and my mind!
You might be surprised, but today, as I am writing this Weekly, is the first time that I thought about this misery since my sale of the entire stake. I shouldn’t have invested, in the first place, because I do not feel very comfortable with this “undervaluation due to complexity”-situations.
I observed, that often the supposed to be “holding-discount”, as it is called, does not resolve. This is one of the reasons why I focus on simplicity. The exclusive research reports for my Premium Members (see here) also contain stocks of companies where I am able to explain in easy words what the whole case is about. If I’m not able to, then I will not write a report about it.
The effect of the sale with a loss was, my mind was free of this ballast. I did not to have to think about a potential turnaround or maybe a sharper decline anymore! I learned where I was wrong in my assumptions and accordingly drew my consequences.
I still do not regret it!
To finish this section, Peter Lynch said the following:
There is no shame in losing money on a stock. Everybody does it.
Peter Lynch, (see here)
What is shameful is to hold on to a stock, or worse, to buy more of it when the fundamentals are deteriorating.
Let’s now go over to the next section where we shift our focus to what really counts.
What to do instead: Focus on your winners!
What I just described above, is active portfolio management and honesty with oneself. From time to time, you have to rethink an original investment thesis and if necessary to pull the trigger.
Of course, the holding period was far from ideal in my example above. But as you can see in the chart of BHC, if I had held on to that stock, I would have made practically no gains and just taken up space in my head and portfolio. I was just doing what was rational. Failed thesis, failed investment. Goodbye (or not)!
You might say that this sounds easier than it is. But I can assure you, if you’ve done it a few times, you will be unemotionally consistent in this regard.
With this approach, I can not only shake off burdening thoughts and feel significantly less stressed. Hand in hand with this goes the focus on what really counts as an investor: Focus on your winners, not your losers!
You just need a few big winners to have a sufficient overall performance with your whole portfolio.
Again, a quote from Peter Lynch, to make this point clear:
All you need for a lifetime of successful investing is a few big winners, and the pluses from those will overwhelm the minuses from the stocks that don’t work out.
Peter Lynch, (see here)
As you will know, shares can only lose up to 100% (if you are not leveraged) – hopefully you won’t ever have such positions in your portfolio…
But on the other side, the upside potential, theoretically, is not limited! You can make several hundred or even thousand percent with one single stock investment! You don’t even need to find the “next Apple (ISIN: US0378331005, Ticker: AAPL) or Amazon (ISIN: US0231351067, Ticker: AMZN)” to achieve this!
Your losses will be more than balanced out with just one or two very good performers.
Let’s take a look at two examples I created to stress my point.
Below, you see a fictional portfolio and some performance numbers. For simplicity reasons, I assumed that every single position was bought with the same weighting and there were no further transactions and no dividends received or reinvested.
Just the performance numbers are slightly different in both scenarios.
First, the portfolio with many failures:
- two total blackouts
- 8 out of 15 positions with losses
- 10 out of 15 positions with no gains / only 5 positions with gains
- only 4 positions with at least 10% performance
- one multibagger (in this case 5x)
You see, even with this catastrophic individual performance numbers, your total portfolio would still have a minor gain of +4.7%.
This is because the one big winner in the line-up at one point in time has such a high weighting that it does not matter anymore whether a few of the stocks in the portfolio will have –10% or –50%!
One big home run has enough power to pull up you whole portfolio!
What if we had a less-disastrous, but still far away from brilliant example? Again, 15 positions with different performance numbers, as follows:
- still one total blackout
- 6 out of 15 positions with losses
- 8 out of 15 positions with no gains / only 7 positions with gains
- 5 positions with at least 10% performance
- one stock with a gain of 50%
- one multibagger (also 5x)
And see here, this also not so overwhelming portfolio (on an individual basis) is able to give you a total return of 20.3%, though more than half of the positions did not contribute anything to the overall results!
Don’t get involved with the losers in your portfolio and don’t sell your winners too early! The rest is a self-fulfilling prophecy.
To have success with stock investing, it is not only necessary to pick some of the right ones, you also have to get rid of those unlikely delivering any performance and even blocking your capital from being invested into such bis compounders. This is important to understand.
When you eliminate the losers early enough and don’t touch the winners, it will be nearly impossible not to earn anything with stocks.
To finally hammer this concept into your mind, take the following analogy:
Imagine, you are a gardener. In all likelihood, you will water your most beautiful flowers and pull out the weeds. I don’t think you would do the other way around and water the weeds and cut the flowers prematurely.
Unfortunately, this is what most “investors” do. Throw out the flowers and fertilize the useless garbage.
Or, to have Peter Lynch saying it (for the last time, today):
You won’t improve results by pulling out the flowers and watering the weeds.
Peter Lynch (see here)
If you cut the winners and buy more of the losers, you will consequently end up with a portfolio full of losers! Keep that in mind.
Always be rational and objective. This is also how Warren Buffett and Charlie Munger became so successful. You need to develop the skill of unbiased questioning of your investments. You do not marry them, you own them for a different reason!
Or as Charlie said analogously: You have to learn to admit when you were wrong! Only a very confident person is able to freely admit when they’ve made a mistake.
Be that confident!
Conclusion
Shares that have fallen, can fall even more. The same applies to stocks that have risen. They can rise even more!
This way, don’t let your psychology or wrong mindset guide you into irrational behavior. Understand from a fundamental point of view what you own and hold onto the winners as long as the fundamentals are intact or become even better.
Don’s sell stocks just because they have risen already to some degree. Likewise, do not load up on more garbage, only because stocks have fallen.
You can make up your losses with a few big winners! Just reinvest your losses accordingly.
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