Investing Principle #9 – Don’t Throw Good Money After Bad

This is part of a larger article called The Golden Rules…

Hold on to your winners and sell your losers, don’t throw good money after bad. While this is actually a component of investor psychology, I thought it was important enough to include in my top 10 list of investing principles.

Sounds silly doesn’t it, why would any investor hold on to their losers and sell their winners? Oddly, this is what many people do, and not just beginners. Even seasoned investors will fall into this habit occasionally if they’re not diligent about sticking to their strategy.

Let’s first talk about holding on to losers, almost everyone has done this so it’s an easier concept to absorb. We often put a lot of hard work in selecting investments. By the time we finally hit the “Buy” button we are confident that we’ve made a wise and profitable choice. However, investing is a numbers game, we can’t be right every time and we will inevitably pick losers now and then.

When this happens, rather than realizing that we either missed something when we did our research or that something has fundamentally changed about the company or the market, many of us still stubbornly believe that we made a good investment. Because we worked so hard to identify a good stock, we find it hard to believe that we were wrong. Even if the price is dropping while our other investments are going up we hold onto it because we’re sure the loss is only a temporary correction and that the stock will head back up very soon.

This behavior is frequently referred to as “falling in love” with a stock. We can’t bear to part with a “good” stock and taking losses is psychologically painful so we wind up riding our losers down. This rarely ends well. Eventually, we realize that no recovery is in sight and we sell the stock back into the market at a much larger loss than we should have taken.

On the other side of the equation, when we review our portfolio and see that investment has done particularly well, we are often tempted to make a profit because we don’t think that any company can sustain such exceptional performance for long. Stock investors are more likely to behave this way than fund investors since they are looking at individual stocks but it can happen to anyone.

Let’s use Google for an example again. The company’s IPO occurred in August 2004 and many of the early investors bought in for between $90 and $110. By April of the following year, the stock was already trading at about $180 but the stock price had been flat for several months and appeared to have hit resistance. As a result, there was an enormous amount of sales volume in April. Had Google’s growth potential or business environment changed? No, the selling was simply early profit-taking by skittish investors. Four months later on the one-year anniversary, the stock was trading at $300. By the third anniversary in 2007, the stock was trading for $510. Ouch, painful lesson.

 

Let’s recap Principle #9…
As painful as it is to take a loss, smart investors set sell limits for every investment that they buy. If it gets close to that limit, they reevaluate to see if they erred in their research or if something has fundamentally changed. Regardless of the situation, if the investment hits the sell limit, they get rid of it, they don’t ever hold on hoping it will go up because they know their money will be better off working for them elsewhere.

On the other side of the equation, avoid selling winners by doing as much homework before you sell as you did before you bought. If the company still meets all of the criteria for your strategy, isn’t it still a winner and shouldn’t you hold onto it? Trust your strategy and hold onto an investment that still meets all of your buy criteria, there is no limit to how high a stock can go so price appreciation should get you excited, not scare you to the sidelines.

Don’t throw good money after bad. If you hold onto losers or sell winners, you are not managing your money efficiently and this will kill your returns. The easiest way to correct this behavior is to stay objective with every investing decision and stick to your strategy, never let your emotions make investment decisions for you.

Best of luck and please add your thoughts to this post, we’ll all benefit from your questions and insights.
~ Odd

Back to main article, The Golden Rules…

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