x Abu Dhabi, UAETuesday 25 July 2017

Knowing when to cut your financial losses is an art form

If, as an investor, your original objective was to buy capital growth and the company is no longer growing, you are in the wrong type of stock and you must admit defeat.

Investors should do plenty of research before taking the plunge on stock markets. However, experts advise that if a stock is doing badly, it is better to sell it before it's too late. Itsuo Inouye / AP
Investors should do plenty of research before taking the plunge on stock markets. However, experts advise that if a stock is doing badly, it is better to sell it before it's too late. Itsuo Inouye / AP

Nobody likes losing money. Absolutely nobody. That's one of the few things that can be safely said about almost every single person on the planet.

Losing money is no fun. We try to avoid it whenever we can. All of us.

But if you're investing in stocks and shares, at some point, you will definitely lose money. When stock markets crash, you could lose a lot of money in a few hours.

Every time you invest in a stock or mutual fund, you are effectively taking a gamble, a gamble you could lose. And it will hurt.

In today's volatile markets, the value of your share holdings can plunge 4 per cent or even 5 per cent in a single day. If your portfolio is worth US$100,000 (Dh367,300), you are instantly down $5,000. And the larger your portfolio, the more money you will lose.

How you react to a losing investment is crucial. So how should you respond?

If you lose money on a stock, don't just dump it in disgust, says Tom Stevenson, the investment director at Fidelity International, the fund manager.

"Your first step is to work out exactly why it has fallen. Is this just a blip, or is there a fundamental problem with the company? If the company is basically sound, you should stick with it. But if the original reason that drew you to the stock no longer holds good, then you should sell."

You have to judge each situation on its merits, Mr Stevenson says. "But if you do cut your losses, you should sell it sooner rather than later because it could always fall further."

That's easier said than done. Investors don't like to admit they have made a mistake. And they really don't like losing money.

The result is that many cling onto a failing stock in the hope that it will recover. "There is an old investment adage that says you should run your profits and cut your losses, but in practice, people tend to do the exact opposite," Mr Stevenson says. "They are too quick to take a profit and let their losses run and run."

Perhaps the biggest challenge investors face is their own psychology, he adds. "It is more painful to lose money than it is pleasurable to make money, even if we're talking about exactly the same amount. That's how our minds work. Many investors find this difficult to cope with. It tends to make them risk averse, which can cost them in the longer run. You have to be aware of this psychological bias when deciding whether to sell."

The best way to avoid losing a large sum of money is to do your initial stock research very carefully, says Kenneth Warnock, the investment manager at Alliance Trust Investments.

"Before buying a stock, you need to spend time researching the company to see exactly what it does, what its prospects are and what is likely to happen to its sector," Mr Warnock says. "That reduces the chance of nasty surprises."

You can't protect yourself against shock "Black Swan" events, such as the Exxon Valdez oil spill in Alaska in 1989, the BP Deepwater Horizon disaster in the Gulf of Mexico in 2010, or the recent sinking of the Carnival Corporation-owned Costa Concordia cruise ship off the coast of Italy. Investors will always be vulnerable to these. But you can limit your exposure to more routine dangers, such as a profit warning, or a hungry young competitor threatening its business model.

You also have to accept that you will get some decisions wrong. "Even the best fund managers may only get it right 55 per cent of the time. That's enough. You just need to get more things right than you get wrong," Mr Warnock says.

So how do you react when you do get it wrong? "More often than not, our advice would be to sell the share. You have called the stock wrong, it didn't perform as you expected and seven out of 10 times it is wise to cut your losses and move on."

Go back to your original research and see if the investment case still holds good. If your original objective was to buy capital growth and the company is no longer growing, you are in the wrong type of stock. "Never fall in love with a stock," Mr Warnock says. "Our default position is: if it hasn't lived up to its objectives, then you should sell."

To do this, you have to fight against the natural desire to see the stock return to the price you paid for it.

"That's an incredibly powerful, but meaningless, desire. You could be hanging on for years. Don't get hung up on your mistakes. What matters is where the stock goes next," Mr Warnock says.

You may stand a better chance of regaining your capital by investing in another stock rather than sticking with your existing one. "You will also feel much better if you get the monkey off your back and simply sell that investment."

Once you have sold, whatever you do, don't look back. "It is irrelevant what happens to it next, so forget about it. You don't own it and you aren't going to buy it again, so why torture yourself?"

Bizarrely, some long-term investors actually celebrate when a share they hold falls in value. If they still believe there is a strong investment case for that company, a short-term dip allows them to top up their holdings at a lower price.

This is called catching a falling knife and it's a dangerous game to play, Mr Warnock says. "It is very tempting to buy a company whose share price has fallen because it is cheaper. The danger is that it may continue falling for weeks or months. The chance of buying at the exact bottom are nearly zero."

Deciding what to do with a mutual fund that is losing money is somewhat different, says James Thomas, the regional director at Acuma Wealth Management in Dubai.

Funds minimise the damage caused by individual company failure by spreading your money between 30 or 50 different stocks - possibly more. "You can reduce risk further by investing in a diversified range of funds," Mr Thomas says. "If you have protected yourself in this way, I would generally recommend holding onto a fund that has fallen in value and remain invested for the longer term."

Different sectors, markets and countries constantly swing in and out of fashion. If you ditch every losing fund and put the money into a recent winner, you will repeatedly end up selling low and buying high, which is a recipe for disaster.

You certainly shouldn't ditch your funds after a market shock, such as the September 11 terrorist attacks and the collapse of Lehman Brothers, both of which sparked a general sell-off. "Within 18 months, markets had recovered and most funds were back in positive territory. If you had sold shortly after these events, you would have missed out on the recovery," Mr Thomas says.

But if the fund under performs its benchmark year after year, at some point you have to make the decision to let it go.

Everybody who invests in stocks and shares should brace themselves for short-term volatility. Remember that if a stock or fund falls in value, you have suffered a paper loss, you only lose real money when you sell. "If you invest for the medium- to long-term, at least five or 10 years, you have plenty of time to wait for your fund to recover."

Mr Thomas says every investor must understand exactly how much risk they are taking when buying stocks or funds and prepare themselves for setbacks.

Your attitude to risk depends on several personal factors. The younger you are, the more risks you can afford to take because you have longer to recover your losses. The richer you are, the more chances you can take because you have a greater financial safety net.

You should also consider the effect any share price setback will have on your everyday finances, says Tim Harvey, the director of Offshore Online, the expatriate financial advisers.

"You need to ask yourself what would happen if you suffered a 30 per cent loss on your investments over the next five years," he says. "Can you still do everything you plan to do? Can you afford, say, your daughter's wedding, your son's deposit on his first house, regular cruises or replacing the car? If you can, any loss will be much less painful. But if you can't, you really do need to reduce your exposure to risk."

You also need to remember that the capital value of a stock isn't everything. Many stocks and funds also yield a generous dividend. "The share price may fall, but if it provides a reliable dividend stream, you might still want to hold onto it. Over the longer term, dividend income often produces more reliable returns than share performance," Mr Harvey says.

There are three basic ways to respond to a falling investment. You can dump the stock. You can hang on and hope for the best. Or you can buy more of it.

Whichever option you choose, make sure you're doing it for sound investment reasons rather than questionable psychological ones. Losing money always hurts, but if you're investing in the stock market, you had better get used to it. With time and patience, and careful stock and fund selection, you should gain a lot more money than you lose. And that's rather more fun.