In your personal life too if you fancy it, but today I’m talking about avoiding losing stocks.
MATH states that losers should be sold immediately and winners should be held. However, why do we continue to fall in love with losing stocks hoping for a recovery when it ends up costing us BIG.
Our losses are in fact greater than what meets the eye. If we benchmark the performance of the S&P 500 at 8% per year, your goal should be to beat the benchmark, otherwise why not simply invest in the S&P 500 (SPY)? A good hit rate paired with avoiding catastrophic losses will make you a successful investor.
To illustrate the fact that our losses are greater than they seem, let’s look at the example below. The concept is taking a 100K portfolio spread out between 10 holdings, each earning 8% per year, except, in Year One Investment 1 achieves a -16% return and then recovers back to 8% per year until year 10. Investor folly is such that we would see that we made money over a ten year period and would be glad that our loss recovered and maybe we even chalked it up to a good decision to have a loss in our portfolio. Wrong. Losers cost you big time and if you had allocated into a better holding instead of taking the loss one could’ve achieved an even greater return at the same level of risk.
After year one you would see that you had a net gain of 5.6% and your loss of 16% in stock 1 cost you [(10,000 * -16%) = -$1,600]. The problem is that this loss actually costed you closer to –$4,791. This loss is almost TRIPLE what you had expected. This is only one holding out of your 10! Imagine you have more than one loser in your portfolio, your chances of competing with the S&P 500 are now slim to none! Each individual portfolio loss comes at the opportunity cost of that dollar being invested elsewhere. To stay on top of our game, we have a CHOPPING BLOCK where we are always analyzing bottom performers and trying to be sure that they still have merit in our portfolio.
No one has a magical crystal ball where we can predict when a stock will take a significant drop or when a stock will recover, however, we need to be honest with ourselves, sell losers, and keep our egos at bay. The old way of thinking is to hold these losers and wait until they bear fruit. MATH says otherwise! The scenario I spelled out below is actually not terrible, after the first year the stock recovers to earn 8% per year for 9 years. This is hardly the case with most losers! If the stock instead lost 16% per year until year 10 the impact on total portfolio performance would’ve been an astounding -$20,000.
Remember that a 50% loss needs a 100% gain in order to recover!
Our portfolio goal is to beat the S&P 500 and as such as we need to have a strategy in order to do so. Thus far, we are up 50% in 1.5 years which is well above market performance.
If we can teach one thing, it is the importance of avoiding losers in your portfolio and picking Wide-Moat Profitable Growth businesses that will beat inflation (and the general market) over the long-term.
Thanks for reading!