Why it May Pay to Sell, Even at a Loss
"When should I sell?" This is the most common question I am asked in trading workshops and individual client meetings. It’s also one of the most important. Failure to clearly define your rules for selling a position can lead to your holding onto large losses or letting large profits slip away. Why? It’s simple: Emotions get in the way.
In this article, we’ll take a look at some common behavioral tendencies that keep investors from selling. Then, we’ll explore how to develop your own personal sell discipline.
Reasons for holding out
“We have met the enemy and he is us,” a famous saying observes. Investors who have selling issues know this all too well. They may enter a trade with a clear notion of when they will exit, but then abandon those plans—because of one of these behavioral lapses:
1. Greed and fear
Greed and fear are the dominant emotions investors must battle every day. No one has ever bought a stock in the expectation it will drop in value. When the market moves against us, the first emotion we experience is fear: “Uh-oh, I’m losing money!” Yet greed steps in and whispers softly into our ears “if you wait until it recovers, you won’t lose money.”
This train of thought leads to what I call “the nastiest four-letter words in trading.”
- Hope: “I hope it goes back up!” As Liz Ann Sonders, Schwab’s Chief Investment Strategist, has observed many times: “Buy and hold” has now been replaced with “buy and hope.” Liz Ann says, “Hope is not an investment strategy.”
- Know: “But I know it will go back up!” The more research we have done on a company, the more confident we are in our decision to buy its stock and to continue to hold it, even at a loss. And the more familiar we are with the company, the more likely we are to follow this pattern of behavior. While there is an investing style to buy companies whose products we know and like, the reality is that nobody ‘knows’ anything about the future price of a stock nor the future course of the markets in general.
- Can’t: “It can’t go any lower.” The only lower limit to a stock’s potential price is zero. If it is not trading at zero yet, it can in fact go lower.
2. Status quo bias
Choosing not to decide is still a decision. When you think about taking a loss, it may be less painful to cling to the hope that a rebound in price erases the loss, versus the certain realization of taking that loss. I have often heard the line: “It is only a paper loss until I sell.” Funny, yet I cannot recall an investor ever saying: “It is only a paper profit until I sell.”
3. The endowment effect
This is the behavioral tendency to overvalue something we already own: when it comes to selling a stock we own, it is mentally difficult for us to sell for less when we have seen the stock trade at a higher price. We tend to feel that we are entitled to that price now. Here are two examples in the following chart:
4. Loss aversion
Another principle of behavioral finance theory is our natural aversion to realizing losses. It has been said that a 10% loss hurts at least twice as much as a 10% gain feels good. When we add status quo bias and the endowment effect, it is easy to see where loss aversion gets it power over our decisions.
Profits versus wins—the overwhelming desire to be “right”
You don’t have to be a “type a” personality to make this common error in investing; most people are conditioned to be “right.” To get your driver’s license, pass an exam, ace an interview—you must get the answers right. However, this mentality can overwhelm and compromise your trading results.
Many individual investors I have worked with over time demonstrate through their actions that they would rather realize a winning trade, even if it isn’t all that profitable. They focus on their win/loss ratio, or how often they are correct in a buy decision that gains in price. Yet far more important to trading success is the ratio of average dollars won per winning trade versus average dollars lost per losing trade.
Many professional traders have win/loss ratios well below 50%, yet they are very profitable because their primary focus is upon keeping the inevitable losses very small relative to the size of their gains.
If there is a golden rule of trading, it is these six words: cut your losses short, let your profits run. To honor this rule, almost all trades should end in a big win, a small win, or a small loss. There should be very few, if any, big losses.
Final thoughts—preserving your trading capital
Above all else, a trader’s key focus should be on preserving their trading capital.
Occasionally, there is a surprise news story that causes the price of a stock to drop significantly. When the unexpected happens, you may want to sell first and ask questions later.
Before entering any trade, you should have an answer for two key questions:
- To preserve my profits, where should I consider selling at least part of my position if the price goes up?
- To preserve my capital, where will I sell my position if the price drops?
When asking yourself these questions, keep in mind “your first loss is your best loss.”