Choosing Not to Own a Loser

by | Aug 1, 2008 | Weekly Column

loser.jpgBecause I encourage clients to invest for the long term, I tend to be an optimist when it comes to the economy. Economic cycles are normal, and the one thing we can be sure of is that markets will go up and markets will go down. If a portfolio is properly diversified, however, with five or more asset classes, it will withstand economic fluctuations with little damage.

One of my first goals with new clients is to make sure their portfolios have that diversification. With the recent decline in the stock market, it’s not unusual for them to have investments in individual stocks which have decreased significantly in value since they were purchased. I usually recommend selling those stocks. I believe it is rarely a good idea for individual investors to own stocks directly, and in most cases they will be better off to sell and reinvest the proceeds in equity mutual funds.

Selling an investment that has lost value is often very difficult. In my experience, it’s common for clients to want to hang on, waiting and hoping the value will come back to the original purchase price of the stock. The reason for this is fairly simple. Making the decision to sell means the client will have to recognize and accept that this investment was a loss, and then become willing to let the investment go. Often the rationalization is, “it’s just a paper loss.” The truth is that a loss is a loss, paper or otherwise.

Making the decision to sell a loser is much easier to say than to do. It requires accepting the reality that your losing.jpgearlier decision has not worked out well and that it’s time to make a new and wiser decision. For clients in this situation, I’ve found it helpful to explain that every day you keep an investment, you are essentially making a new decision to own it. Keeping a sum of money in a losing investment is not really any different from choosing to put a new sum of money into that same investment.

Suppose you bought some shares of XYZ stock for $30,000. Right now it’s worth $10,000. It is natural to think, “I can’t sell this now, I’ll lose $20,000. I have to wait until it comes back.” Based on my analysis, though, it isn’t likely that this stock is going to come back. The remaining $10,000 is probably going to follow the $20,000 that has already gone down the drain. Or it may indeed come back, eventually. The cost then will be the lost opportunity to do better in a more diversified portfolio.

One strategy that can be helpful in a situation like this is to separate the money this investment is worth from the investment itself. What you have isn’t really a certain number of shares of XYZ stock; what you have is $10,000. Right now that money is sitting in a losing investment. You can leave it there on the remote chance that it will eventually start earning a return again, or you can put that $10,000 into something else where it will have a better chance of making more money.

easy-button.jpgAnother way of describing this same choice is to ask yourself what you would do today with a fresh $10,000 to invest. Would you put it into XYZ stock? Almost certainly not. Why, then, would you want to keep your current $10,000 there?

When you sell a losing investment, you aren’t giving up something of value. Instead, you’re choosing not to own something that is losing value. When you think of it this way, the decision to sell can become a little easier.

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