How to recover losses in the stock market
Should you buy more of losing stocks like Tata Elxsi or Nykaa or exit them?
Market NewsEquitymasterUpdated: October 25, 2022 11:51 am IST
Annie Duke has an interesting take on how to deal with losing stocks.
Who is Annie Duke you may ask? Well, she wears many hats.
She’s an author of a national bestseller. She is the only female world series of poker champion. And she is also a national science foundation fellowship awardee, all rolled into one.
That’s quite a resume to be honest. Which is why when Annie Duke speaks, especially around things like decision making and psychology, it pays to listen.
Well, Annie did speak a lot recently, on a podcast that was full of insights and where she covered a lot of ground. The part that interested me the most was around losing stocks and how to deal with them.
Annie is of the view that every person should first recognise that he or she is not rational or a good decision maker all the time.
There are times when one makes good, well thought out decisions and there are times when one makes terrible, irrational decisions based more on emotions and less on logic and sound reasoning.
When it comes to investing, a person is the most vulnerable to a terrible decision when he is sitting on a significant loss. As per Annie, majority of the investors don’t want to swallow the bitter pill of booking losses and moving on. They are totally focussed on getting their full money back.
In fact, most of the times the stress of sitting on a loss reaches levels where the investor can’t make a rational decision anymore. And this is when things really take a turn for the worse. Instead of stopping the digging when they find themselves in a hole, their digging intensifies.
They come up with all sorts of reasons to think they’re being rational in continuing on. But the harsh reality is that they’re being irrational. They don’t want to bite the bullet and face the difficult choice of having to take the big loss.
I think Annie is bang on. Ask any experienced investor about his biggest mistakes and I’m sure this irrationality of holding on to losers for too long would be somewhere near the top of the list.
Ok, so Annie has identified the problem. And most of us probably know that we’re sub-optimal decision makers when it comes to selling. But how do we address it? What should we do so that we minimise this error in the future?
Well, Annie has a simple solution to this difficult problem. She opines that you better set up things in advance that will stop you from making a rash decision when you are stressed or are sitting on a big loss.
I think what she is trying to say is just as traders have stop losses, investors should also a pre-determined sell rule. They should decide in advance when they will sell a particular stock. And once we decide on the rule, we should stick to it come what may.
For example this rule can be either selling at the end of two years or after a 50-100% profits, whichever is earlier. This rule will help you in making substantial profits from your winners and will also prevent you from holding on to your losers for too long.
Does this apply to currently losing stocks like Tata Elxsi and Nykaa?
If someone has bought these stocks a few months back and is now sitting on a significant loss, should he exit right now or should he stay invested for the next 2-3 years at least?
Well, it all depends on what kind of a selling rule he has fixed for himself in advance. That in turn depends on the kind of investor that he is.
If he is a trader and if the stocks have fallen below his stop-loss limit, then exiting does make sense. Holding on to the losing position would mean he is acting irrationally and is not willing to turn his paper loss into an actual realised loss. It’s certainly not a wise thing to do in my view.
On the other hand, if the person is an investor and wants to make at least 50-100% on every investment and is willing to wait for 2-3 years, then he should hold on to any or both these stocks. This is provided he thinks they are undervalued stocks.
However, if no real effort at valuing the stock has been taken or the stocks have been bought based on a tip or a recommendation from a friend, then one is acting irrationally and purely out of greed in my view. Such an investor should certainly exit the stocks.
And last but not the least, what if one’s holding period is beyond 2-3 years? What if one is a very long-term investor and wants to hold these stocks for 5 years and even beyond?
Well, for such an investor who is really convinced about the long-term potential of these stocks, the correct option would not be exiting but buying every significant dip in the stock price.
If he has a thorough understanding of these businesses and is confident they will create new profit records 10-years from now, then every fall is an opportunity to buy and not sell.
However, more than the growth such investors such really be looking at whether these companies have any kind of sustainable competitive advantage.
This advantage could either be in the form of either providing the same product or service at a cheaper price than the rest of the competition or of a much better quality such that customers are willing to pay a premium for it.
If any of these advantages are missing, these companies could be highly vulnerable to competition coming in and taking market share away or shrinking profit margins.
Therefore, more than the growth in profits, it’s the sustainable competitive advantage that matters. Those who are really long-term investors in these stocks should thoroughly check for the presence of these advantages.
So there it is, a reliable way to deal with losing stocks like Tata Elxsi and Nykaa. One that allows you to use logic and sound reasoning and does not leave you at the mercy of emotions and sub-optimal decision making.
It works by allowing you to ask yourself what kind of an investor you are and then formulating your sell rule accordingly.
Once formed, please stick to them at all times, irrespective of whether it involves exiting at a significant loss from time to time.
These losses are necessary for they lay the foundation for your future winners and ensure that you don’t overstay your welcome in dead investments.
This article is syndicated from Equitymaster.com.
Source: NDTV