When Should I Cut Losses On A Declining Stock?

This article is written as part of a DollarsAndSense.sg collaboration with For Tomorrow. For Tomorrow is brought to you by Temasek, in partnership with MoneySmart and DollarsAndSense. All views expressed in the article are the independent opinion of DollarsAndSense.sg

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Anyone can make money in the stock market when things are going well. Knowing when to hold’em is the easy part; knowing when to fold’em separates the successful investors from the less successful ones. 

Every investor would have heard the phrase “take emotions out of your investing strategy”. This is much easier said than done. The minute we buy a stock, many of us start worrying about losing money.

Common questions you start asking yourself include “Did I buy at the right price?”, “Is this bull market about to end?” or “Is this stock really a good investment?”. 

When the stock market actually turns red, these questions quickly morph into:

• Uncertainty – whether to continue buying the stock at its current lower price and to average down your purchase cost
• Full-blown Paranoia – that investing just isn’t for you
• Deep Remorse – about making a rash decision to buy the stock in the first place.

This article aims to veer your thought process in a healthier direction so that you can make a more informed decision on whether you should sell, hold or even buy more when the market moves against you.

When you are struggling to figure out what you should do with a stock that is at a loss, you can consider these 4 factors.

# 1 Mistakenly Investing In A “Lemon”
Question the reason you invested in the stock in the first place. You must have made the investment for a concrete reason, we hope. Perhaps you thought that the stock was underpriced when compared to similar companies. Perhaps you identified a defensive stock that you thought would do well for the long term, or believed a sector would improve after experiencing some headwinds.

If you’d actually choose to buy more of the stock and average down the purchase price, this means you continue to believe you have made the right decision in investing into the company in the first place, despite its current struggles. If that’s the case, it may be a good idea to hold on to this investment for now and to ride out market volatility in the short-term, rather than to panic-sell.

If you’re second-guessing your thought process, you have to consider the possibility that you were wrong in your assessment of the stock in the first place.

It could be that the stock was underpriced because it was a poorly managed company.

Perhaps its seemingly defensive business might have lost out to competitors who actually provided more value for customers, or the sector you believed would improve did, but the company you invested in didn’t.

It’s okay to be wrong. You just need to know it and cut your losses sooner rather than to stubbornly hope that the market would somehow turn in your favor for no good reasons.

If you are unable to remember your reason for buying the stock, then we would say you have no business owning it in the first place.

# 2 When The Company Is No Longer The One You Invested In
No, we’re not saying you got scammed.

When the markets move against you, you need to re-assess your investment thesis. This is slightly different from the first point, where you invested in a bad company in the first place.

What we are saying here is that you’ve invested in a company whose fundamentals have changed since you invested into it. What used to be a good company may no longer be so today. This is part and parcel of the business world.

When the company you invest in fundamentally shifts, either by selling a part of its business, expanding its mandate to new areas of business, undergoing a merger or acquisition, or even undergoing a change in management, the rationale for your original investment often becomes irrelevant.

You should reassess the company growth potential and what are its (new) plans moving forward, its balance sheet and profit and loss statements and the management’s ability to deliver on its promise to make an independent decision on whether you still want to stay invested in it.

Beyond just a change in management, there are also other external factors that could affect a company’s ability to perform. For example, an increase in competition and technology advancement may cause an otherwise strong company to face bleaker growth prospect in the future.

# 3 Setting A Stop-Loss Target
Even if you think your investment could still turn out well in the long-term, you may not want to risk so much of your money believing in your judgment. Investors may not like to admit they’re wrong, but it happens more often than many of us would like.

One easy way is to set a target for yourself; if a stock falls below a certain price level, for example, you would simply sell, regardless of the reason.

This way, you never risk more than a fixed percentage of your portfolio, and you’re still able to let your good investments ride upwards.

Of course, having a stop-loss target can lead to some regrets in the future, when you see some of the stocks that you sold off eventually recovering.

This strategy needs to be seen through the lens of an entire portfolio. By limiting the downside in wrong investment decisions that you make, and letting the right decisions ride upwards, you will enjoy more gains than losses as a portfolio, though you will still make some losses on individual stocks.

# 4 Selling In Extremely Volatile Markets
In extremely volatile markets, you could easily and quickly lose 20% or even 50% of your initial investment. Recovering from these types of losses can take a very long time, and may sometimes never materialize.

It is also overly simplistic to think that stocks always bounce back. In some cases, bad companies just go bust in economic downturns.

And, while it’s true some companies do eventually bounce back, it could take a long time to just get back to square one.

Consider incurring a 50% loss, you would need the investment to gain 100% just to break even. Even if you lose just 20%, you’d still need a 25% recovery to break even.

This means that if you cut your losses earlier, you could re-invest at a lower price at some time in the future, and lower the hurdle to earning a return on your investment. You could also choose to reinvest during a more stable period, even if it’s at a slightly higher price. This beats simply holding and waiting for the stock to recover.

This article is republished with permission from Dollars and Sense.