Chapter 28

Dealing with loss

One of the disadvantages of being an investment writer is that as soon as people find out what I do, they only want to talk to me about stocks. I find that they fall into three categories.

The first, and most disagreeable group, are those who want to regale me with stories of their investments or their investing methods. These are always about their winning investments and are designed to show how clever they are. I try to listen and smile. I smile, because I know that in a drawer somewhere is a pile of papers that evidence all their losing investments.

The second group are those who seem to think I am a guru and that somehow I can bless them with the power to make untold riches without effort. They want me to predict the stock market and to give them stock tips. Unfortunately, they are still looking for magical solutions. No matter what I say, I am always left with the feeling that they think I am keeping the secrets to myself.

The third group are the ones I want to talk about in this chapter. These are the ones who have made investments that have turned out badly and they want to know what to do with them. This is the only one of the three groups to whom I might be able to offer constructive ideas.

Some of the people in this group have only one or two stocks. They were often acquired through their employment or a popular flotation such as Telstra or AMP. These are usually erstwhile solid companies that were floated at unrealistic prices in the boom, or that have got into trouble more recently.

Other members of this group have told me some horrific stories. One that sticks in my mind is the person who invested his savings of $250 000 in technology and internet stocks in early 2000. Eighteen months later those stocks were worth only $30 000. This was the worst example, but there have been many others with a similar percentage loss on a smaller initial investment. The same sorts of stories also crossed my path after the bear market in 2008–09, triggered in part by the global financial crisis. I have met a few investors who owned almost all of the big stocks that collapsed completely.

When asked what I think they should do, my first step is to enquire what their investment plan was when they bought the stocks. This is obvious really: unless I know what they are trying to do, I have no way of considering whether their plan is still intact or not. The answer is always the same: they bought for various reasons, but had no plan.

This tells me immediately why they have these losses. If they did not know what they were trying to do, then they had no way of knowing when it started to go wrong. Therefore they had no reference point for making a decision to get out. It is also why they are asking me the question now. If they had a plan and had followed it, they should not need to ask me what they should do now. That is the logic of their story, but behind it is something quite important. In many cases it turns out that they did make some profits in the boom. Often it was these early profits that sucked them into making the ones that turned out badly. Sometimes these were winners on paper before they turned into losers.

Clearly, these people should have sold the losers a long time ago. They didn’t, because of a tendency well-known in behavioural finance. When faced with a choice between realising a certain profit and a chance of making a larger profit, but with the risk of loss, most people will snatch the certain profit. When faced with a choice between realising a known loss, or hanging in with a chance to get out even, but with a risk the loss could get larger, most people will ride the losing investment. This is the essential thinking driving the loss-making investors. What they have done is the opposite of what good investors do, which is to hang onto their winners and sell their losers.

A rational investor has to struggle with this natural urge to sell winners and ride losers, which feels like the correct thing to do when we start out. An entirely logical investor would reason that they should assess the outlook for the company. This might be through analysing its accounts, management and prospects (known as fundamental analysis). It might also be through looking at what the smart money is doing as shown in its market price performance (known as technical analysis). If their analysis finds that the company is sound and should recover, then they should hold it and be patient. If their analysis suggests that things could get worse, the logical action is to sell out and reinvest the funds in a company with better prospects. Unfortunately, we find too often that investors do not do this, but take one of two other courses:

They hang on to the bad ones, whose losses get worse. Some fool themselves that the loss is not real unless they sell, which is the ultimate delusion. Others argue that they have lost too much to sell now. They, too, are not facing up to the loss, with which they are in denial. Logic says they would be better off in some other investment. No matter how little is left, it is better to be in something going up than something going down that may disappear altogether.

They sell out of the good ones, often just before they recover (called the point of capitulation). This group are giving in to fear, the opposite to greed and one of the most destructive motivations in investing, because all successful investing involves taking on uncertainty. Fear operates in two ways here.

Firstly, fear makes us concentrate on the negatives. Actually, we only see the negatives, which take over all of our thinking. Positives are shut out. When we read some facts about the situation, we tune in to every bad point and either do not even see, or greatly discount, every good point. In some cases we even interpret quite neutral points as being negative.

Secondly, fear makes us place too much weight on the bad news in the past and in the present, so we are unable to imagine a different future.

It is most important to find some way to imagine another future. Consider that if we decide to sell, then someone must want to buy from us. They must have a different view of the future. They might simply realise that, even in the worst situation, prices do not fall in a straight line. They may also be bargain hunting for a quick profit.

On the other hand, they might have a more realistic view of the way the corporate world works. They know that the economy is a dynamic system. Change is constant and bad situations can and will be turned around in otherwise sound companies. We need to find an adviser who can give us the positive view of the facts.

If we find ourselves in the situation of holding losing investments, this is how to begin to deal with the situation:

1 We need to have an investment plan. We may need professional assistance to develop the appropriate plan. My book Building Wealth in the Stock Market sets out my investment plan in detail, which may help as a model.

2 We rearrange our present holdings consistent with that plan. We take each of our current investments and decide whether to hold it or sell it by reference to its prospects compared to alternative investments available to us.

3 As we follow our plan, we sell quickly when things go wrong and hold onto the winners while they perform for us.

4 If an investment suffers a correction in an uptrend, but both fundamental and technical analysis shows that all is well, we should be patient. All uptrends unfold with periods of strong rises followed by corrections before the next rising phase. We should let our plan work.

5 We don’t put all our money in one investment. We spread the risk, so that if one fails badly before we can get out, it is not catastrophic.

Summary

Beginners often start by making big losses on stocks that they rode down from high prices to low. They want to know what to do now. First they need a clear investment plan. Second, they must assess each holding against the plan and alternative opportunities and make rational decisions to rearrange the portfolio. Finally, they must try to follow their plan, cutting losses, while letting profits build.