One of the most enduring sayings on Wall Street is "Cut your losses short and let your winners run." Sage advice, but many investors still appear to do the opposite, selling stocks after a small gain only to watch them head higher, or holding a stock with a small loss, only to see it worsen.
No one will deliberately buy a stock they believe will go down in price and be worth less than what they paid for it. However, buying stocks that drop in value is inherent to the nature of investing. The objective, therefore, is not to avoid losses, but to minimize the losses. Realizing a capital loss before it gets out of hand separates successful investors from the rest. In this article, we'll help you stand out from the crowd and show you how to identify when you should make your move.
Reasons Investors Hold Stocks With Large Unrealized Losses
In spite of the logic for cutting losses short, many small investors are still left holding the proverbial bag. They inevitably end up with a number of stock positions with large unrealized capital losses. At best, it's "dead" money; at worst, it drops further in value and never recovers. Typically, investors believe that the reason they have so many large, unrealized losses is because they bought the stock at the wrong time or it was a matter of bad luck. Rarely do they believe it is because of their own behavioral biases.
Let's look at a few of these biases:
- Stocks Always Bounce Back - Don't They?
A glance at a long-term chart of any major stock index will see a line that moves from the lower-left corner to the upper right. The stock market, over any long time period, will always make new highs. Knowing that the stock market will go higher, investors mistakenly assume that their stocks will eventually bounce back. However, a stock index is made up of successful companies. It is an index of winners. Those less successful stocks may have been part of an index at one time, but if they've dropped significantly in value, they will eventually be replaced by more successful companies. The indexes are always being replenished by dropping the losers and replacing them with winners. Looking at the major indexes tends to overstate the resiliency of the average stock, which does not necessarily bounce back. In fact, many companies never regain their past highs and some go bankrupt.
- Investors Do Not Like Admitting They've Made a Mistake
By avoiding selling a stock at a loss, many investors do not have to admit to themselves that they've made a judgment error. Under the false illusion that it is not a loss until the stock is sold, they elect to continue to hold a losing position. In doing so, they avoid the regret of a bad choice. After a stock suffers a loss, many investors plan to hold onto it until it returns to its purchase price. They intend to sell the stock once they recover this paper loss. This means they will break even, and "erase" their mistake. Unfortunately, many of these same stocks will continue to slide.
When stock portfolios are doing well, investors often tend to them like well-maintained gardens. They show great interest in managing their investments and harvesting the fruits of their labor. However, when their stocks are holding steady or are dropping in value, especially for long time periods, many investors lose interest. As a result, these well-maintained stock portfolios start showing signs of neglect. Rather than weeding out the losers, many investors do nothing at all. Inertia takes over and, instead of pruning their losses, they often let them grow out of control.
- Hope Springs Eternal
Hope is the belief in the possibility of a positive outcome, even though there is some evidence to the contrary. Hope is also one of the primary theological virtues in various religious traditions. Although hope has its place in theology, it does not belong in the cold hard reality of the stock market. In spite of continuing bad news, investors will steadfastly hold onto their losing stocks, based only on the faint hope that they will at least return to the purchase price. The decision to hold is not based on rational analysis or a well-thought-out strategy; and unfortunately, wishing and hoping that a stock will go up does not make it happen.
Realizing Capital Losses
Often you just have to bite the bullet and sell your stock at a loss before those losses get bigger. The first thing to understand is that hope is not a strategy. An investor has to have a logical reason to hold a losing position. The second point is, what you paid for a stock is irrelevant to its future direction. The stock will go up or down based on forces in the stock market, the stock's underlying fundamentals and its future prospects.
Let's look at a few ways of assuring a small loss does not become "dead" money or turn into a much larger loss.
- Have an Investment Strategy
Having a written investment strategy with a set of rules both for buying and selling stocks will provide the discipline to sell stocks before the losses blossom. The strategy could be based on fundamental, technical or quantitative factors.
- Have Reasons to Sell a Stock
An investor generally has quite a few reasons why he or she bought a stock, but typically no set boundaries for when to sell it. Don't let this happen to you. Set reasons to sell stocks, and sell them when these things occur. The reason could be as simple as: "Sell if bad news is released about corporate developments or a price target."
- Set Stop Losses
Having a stop-loss order on shares that you own, particularly the more volatile stocks, has been a mainstay of advice on this subject. The stop-loss order prevents your emotions from taking over and will limit your losses.
- Would You Buy the Stock Now?
On a regular basis, review every stock you hold and ask yourself the simple question: "If I did not own this stock, would I buy it today?" If the answer is a resounding "No", then it should be sold.
Tax-Loss Harvesting Strategies
A tax-loss harvesting strategy is used to realize capital losses on a regular basis and provides some discipline against holding losing stocks for extended time periods. To put your stock sales in a more positive light, remember that you receive tax credits that can be used to offset taxes on your capital gains.
Taking corrective action before your losses worsen is always a good strategy. In investing, avoiding losses entirely may not be possible; successful investors accept this and try to minimize their losses rather than avoid them. Selling a stock at a loss and receiving a tax credit is one benefit you will receive. Selling these "dogs" has another advantage too - you will not be reminded of your past mistake every time you look at your investment statement.
Personal FinanceTempting as it is to pass the buck for your losses, the true culprit may be closer to home.
Investing BasicsCapital losses are never fun to incur, but they can reduce your taxable income. Knowing the rules for capital losses can help you maximize your deductions and make better choices about when to ...
Options & FuturesAdopting realistic expectations is essential to staying in the trading game.
Forex EducationWhen approached as a business, forex trading can be profitable and rewarding. Find out what you need to do to avoid big losses as a beginner.
Mutual Funds & ETFsDiscover five bear market mutual funds that investors can turn to for generating maximum capital appreciation during a bear market.
Mutual Funds & ETFsExplore detailed analysis and information of the top three Swiss exchange-traded funds that offer exposure to the Swiss equities market.
SavingsWomen's risk aversion, penchant for research – and lack of male-style "irrational exuberance" – means their investing strategies often put them ahead.
SavingsPrices for oil and natural gas are highly correlated. But investors should be aware of different factors affecting the prices of these commodities.
Technical IndicatorsThinking of trading in risky penny stocks? Use this checklist to find bargains, not scams.
Trading StrategiesAlthough penny stocks are highly speculative, millions of people trade them daily. Here are 10 different types who do.
The amount of risk that an insurance company retains after subtracting ...
Coverage that provides financial protection to investors, financial ...
A manager who adjusts a portfolio’s long and short-term positions ...
An investment style that does not require a fund or portfolio ...
A trade where a stock or market appears to be making a move in ...
A trade on the short side with an overwhelmingly large number ...
Because of the small market capitalization and revenues typical of most penny stocks, there are very few that offer dividends. ... Read Full Answer >>
It is possible to trade penny stocks through an individual retirement accounts, or IRA. However, penny stocks are generally ... Read Full Answer >>
Generally, penny stocks are traded through the use of the Over the Counter Bulletin Board (OTCBB) and through pink sheets. ... Read Full Answer >>
Some penny stocks, those using the definition of trading for less than $5 per share, are traded on regular exchanges such ... Read Full Answer >>
The Federal Deposit Insurance Corporation, or FDIC, is a government-run agency that provides protection against losses if ... Read Full Answer >>
One of the best assets a person can have is an individual retirement account (IRA), and children can have one as long as ... Read Full Answer >>