Unfortunately, not all of us make a profit on every trade we make. So what choices do you have, if you have shares showing a paper loss?
There are basically four options:
Sell. Bail out and cut your losses before they get any larger.
Hold. Take the view that the price will come back in a reasonable period of time.
Buy. Buy more shares and average down the cost in anticipation of the price rising in value in a reasonable period.
Write off. Sometimes you might have to recognise that your shares have bombed out.
But which choice is appropriate in what circumstances? That's a difficult question made more complex by the role of emotion.
Clouding the issue is the cognitive bias of loss aversion. There's empirical evidence that people value the avoidance of a loss more than they value making the equivalent gain. For investors, that translates into a tendency to hold onto loss-making shares longer than is advisable to avoid crystallising the loss.
One way some people deal with this is to automate the process, by setting 'stop loss' orders. But that forces you into the sell response when it may not be the best action. Instead, it's helpful to be aware of loss aversion, to psychologically steel yourself to swallow losses.
Of course, the ideal situation would be to be constantly value the shares in your portfolio, compare your assessment to the prevailing price, and make a judgment to buy, sell or hold based on the difference (while taking into account trading costs). In theory, the price we historically paid for shares is irrelevant (except for tax purposes).
But few of us are walking automatons. So it may be useful to have guidelines for which response is likely to be the best in different circumstances.
When to sell
Even the world's greatest investor, Warren Buffett, who has publicly declared that his favourite holding period is 'forever', sells when the conditions are right.
A sell decision doesn't have to be executed immediately. There's no reason why — just as many people have a watch list of shares they want to buy but are waiting for the right time — that you can't have a "sell list" of shares in your portfolio that you plan to sell. Then you can exploit volatility in the price to sell at what seems the best time.
Of course, if you do that you need to be aware of the loss aversion psychology and ensure that you're not, secretly, really waiting for the shares to come back into profit.
Pointers towards a sell decision might be:
- You're a growth investor and/or have a short-term timeframe, and the setback in the shares doesn't look temporary.
- There has been bad news that doesn't look easily fixable.
- If the bad news relates to funding issues that's an especially strong sell signal in the current environment.
- The shares have hit a new low. Ask yourself, whether you think this really is the bottom?
- The dividend has been cut. Directors only do that when desperate measures are called for, and the shares are unlikely to recover before the payout is restored.
- It's a first profit warning. Might there be more to come? An old stock market adage is to sell on the first warning and buy on the third.
Some of the stocks in this category might include: David Jones Limited (ASX: DJS), Billabong International Limited (ASX: BBG), Myer Holdings Limited (ASX: MYR) and TEN Network Holdings Limited (ASX: TEN).
In October 2010, I sold out of Macquarie Group Limited (ASX: MQG) despite incurring a loss. Was I glad then? Yes, I got out of a losing position. Am I still happy now? With the shares currently trading around 20% lower than the price I sold at, absolutely!
Likewise, I sold out of Westfield Group (ASX: WDC) about a year ago, and realised a small loss. With the current price around $1 lower than my sale price, am I happy? Yes again!
When to hold
Pointers to a decision to hold include:
- You're a value investor taking a long-term view.
- You're an income investor receiving a healthy dividend, and there doesn't seem to be a threat to dividend growth.
- The shares are down because the whole market is.
- The shares are within a reasonable price range (it may be that, with hindsight, you didn't time your purchase very well).
- The company is suffering "guilt by association" from bad news at one of its peers. Is it really something that will affect the whole industry?
Woolworths Limited (ASX: WOW) fits this choice for me. The only reason I decided not to buy any more at recent low prices was that I already had a decent allocation to Woolworths in my portfolio.
When to buy
It can be a good strategy to buy more shares if your conviction in the value of the company remains at least as strong as it was before the shares fell – as long as you don't end up with one company making up an overly large proportion of your portfolio. The effect is to lower your average cost of ownership. If the shares recover as hoped, you might then sell the additional shares to rebalance your portfolio – effectively, you've made a profitable decision.
Buy indicators might be:
- You think the market has over-reacted to bad news.
- There has been bad news, such as a string of profit warnings, but there is now a convincing recovery story.
- Directors are buying.
QBE Insurance Limited (ASX: QBE) falls into this category for me. I think the market has overreacted to the bad news. Other investors appear to have taken the same view, with the share price up 19% since early January 2012.
You only have to look at the best time to have bought stocks in the last few years. That was in March 2009, a period when many investors would have been under water, showing paper losses, unless they also decided to sell at that time. Since that time, the S&P/ASX 200 Index is up 28%, and many stocks have recovered from their lows.
The Foolish bottom line
Losses are inevitable but it's best to tackle them head-on. If you have shares in your portfolio that are under water, it might be time for some spring – well, autumn – cleaning!
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Motley Fool contributor Mike King owns shares in QBE and Woolworths. The Motley Fool's purpose is to educate, amuse and enrich investors. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson. Click here to be enlightened by The Motley Fool's disclosure policy.
A version of this article written by Tony Reading, originally appeared on fool.co.uk. It has been updated by Mike King.