One of Wall Street’s most famous sayings is “cut your losses and let your profits run.” In reality, many investors do the opposite, selling winners too early and holding onto losing positions too long (what’s known as the disposition effect).
Behavioral finance tells us that investment decisions are often more about emotions than economics. One method for helping to overcome biases in the investment world is to have a process or a system in place to mute the effects of these biases. In this post, we’ll look at P&A’s sell discipline for individual stocks that haven’t performed as expected.
It should go without saying that every stock purchase is a great idea on trade date. Unfortunately, not all buys work out, especially when you have a minimum of 20 individual stocks in a portfolio. A stock can underperform for company-specific reasons (an earnings miss, a CEO departure, a new competitor, etc.) or general market-related factors (sagging consumer confidence, geopolitical events, higher interest rates, etc.).
We learned an important lesson many years ago. You simply can’t fall in love with a stock or company. Doing so introduces strong emotions, including the desire to be right. So, we created our “Down 20 Rule,” which says any stock we buy for a client account that loses 20% or more from its purchase price is scrutinized for a potential sale. If the company missed earnings and fell significantly below the “Down 20” level, we’re likely to sell. If a stock is down a tad more than 20%, we may give it a little more time to see if it recovers.
This rule came into being as a result of some hard lessons (as Pitt likes to say, “These scars are real”). So why the Down 20 Rule? Besides the emotional reasons listed above, there are three other advantages:
- First, when you find yourself in a hole, stop digging. We’ve seen new client portfolios transfer in that have positions with a loss of 50% or more. Just to get back to even on that stock would require a 100% gain. A loss of 20% merely requires a gain of 25% to get back to even.
- Second, there are potential tax benefits in realizing the loss in an after-tax investment account by transferring it from your portfolio to your tax return. These losses can be used to offset other capital gains, or up to $3,000 can be used against your ordinary income. Any unused losses can be carried forward into future tax years to offset gains or reduce ordinary income.
- And third, this rule helps to address opportunity costs. There’s a tendency of stocks that have fallen significantly to move sideways for some time before attempting to climb back up the mountain. In waiting for this to happen, investors are likely missing out on other stocks that are performing well and not having to win back the trust of investors. The opportunity cost is in forgone gains by sticking with a losing position instead of moving on to something that’s working.
Successful investing requires level-headedness and clear thinking; emotions must be minimized when and where possible. Having a sell discipline helps us avoid falling in love with a stock or company. We’re confident that having this Down 20 Rule in place has saved our clients significant money over the years.
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Pittenger & Anderson, Inc. does not provide tax, legal, or accounting advice. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. You should consult your own tax, legal and accounting advisors before engaging in any transaction.
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