You’ve got to know when to hold ’em
Know when to fold ’em
Know when to walk away
And know when to run
You never count your money
When you’re sittin’ at the table
There’ll be time enough for countin’
When the dealin’s done
-Kenny Rogers, “The Gambler”
That will be the only time you ever see me quote Kenny Rogers — unless I’ve had far too much bourbon and find myself atop a mechanical bull. But that’s a story for another time.
But if you’re an investor, Kenny brings up one of the single biggest hurdles to any successful investment: know when to fold em. Selling a losing stock can be one of the most gut wrenching things you can do. Nobody wants to sell for a loss. But sometimes the best offense is a good defense and holding on to losers can decimate your portfolio faster than you can say “Grand Ole Opry”.
You see, most people spend countless hours agonizing over which stocks to buy. They don’t spend nearly the same effort and time to decide when to unload a poor position.
That’s because psychology kicks in, and it can make it damn near impossible to decide to sell a stock. Much of it comes down to pride…
When you hold a losing position, most investors are overtaken by “loss aversion bias.” That essentially means you do not want to admit you made a mistake. I know I sure as hell don’t like admitting I’m wrong even during mundane, everyday activities (just ask my wife).
But when I (occasionally) do have to finally admit I’m wrong and a boatload of money is at stake… then the fight or flight responses kick in. Humans’ natural default settings are to fight. This can lead to all sorts of backwards justifications on why you should keep holding the stock:
I don’t lose until I sell…
They could turn things around…
Stocks always bounce back… right?
Thinking like that will cost you big every time. So here’s a quick guide to know when to hold em, and more importantly know when to fold em…
It has been proven time and time again that one loss stings more than ten winners. So naturally, you’re more likely to come up with excuses on why to hold something than trying to justifying selling something for a loss. It’s known as “the endowment effect” which means that you unreasonably value something simply because you own it.
This can lead to untold losses…
According to famed investor Philip Fisher, “More money has probably been lost by investors holding a stock they really did not want until they could ‘at least come out even’ than from any other single reason.”
It boils down to the fact that you really just don’t want to seem like a loser.
“As long as the loss is hanging in the portfolio it has a chance of coming back,” according to Michael Ervolini, head of Cabot Research. “But once you sell a position, that position is a loser forever and a little bit of you is a loser forever.”
So I think that we can all agree we don’t want to be losers forever. But make no mistake, as long as a stock is pulling down the rest of your portfolio, you are a loser for as long as it sticks around. Like my mom told me in high school, you are who you hang around with. Don’t waste your time carousing with losers; they start to wear off on you.
Here are three situations where you should cut your losses and move on…
1) When the basis for your investment is no longer true
For example, say you a bought a blue-chip stock based on its history of increasing dividend payments. You were attracted to the fact that it was a solid, growing company that could afford to pay back its success to its shareholders.
But — all of a sudden — the company slashed its dividend.
Now, first thing, if a company slashes its dividend it typically means that things aren’t going very well. That payout is usually the first thing to go when the company isn’t making money hand-over-fist. Also, if you are holding a company that has cut its dividend you are probably too late to avoid a drop in share price. But that small loss shouldn’t cloud your judgment. If you wanted to invest in a dividend aristocrat but now you’re holding a dividend pauper — then it’s time to bail and find another position to take its place.
The key question to ask yourself is, “If I found out about this company today, would I still buy it?”
If the answer is a resounding “Hell no!” the you should cut it loose and find a better place to park your money. In this situation, there are always more attractive positions out there.
2) Insiders are dumping their shares
This pretty much goes without saying. If the guys who have access to all of the information about a company start selling off shares, they probably aren’t too bullish about whatever news is about to come out. If they aren’t betting on the stock going up, then you should at least be on alert that the next earnings statements won’t be positive.
Now, sometimes even big-time CEOs want to diversify their portfolios. Sometimes they may want to liquidate their shares to buy an exotic island, a new Lear jet or — most likely — pay for an incredibly expensive divorce. But usually, if they are selling their positions, you need to keep an eye on the stock.
By and large, insider trading is a valuable instrument in measuring big-time interest in a particular stock.
You also need to familiarize yourself with what really makes an insider. According to Nejat Seyhun, one of the world’s leading researchers of insider behavior, you should really be looking at a company’s officers and directors: CEOs, CFOs, etc. These are the guys that know exactly what is coming down the pike and are light years ahead of media talking heads, hedge fund analysts, and of course, individual investors like you and me.
If all of them are selling at once, you have a serious problem afoot.
Other investors may own more shares overall, but they aren’t always privy to the companies inner-workings.
So if you take a glance at the officers and directors 13F filings — the quarterly report filed, per SEC regulations, of equity holdings — and you see the company brass selling off a big chunk of stock, you should at least be concerned about the upcoming quarter, and at most think of selling off before whatever news they know that isn’t yet public makes it into the Wall Street Journal next month.
It is also prudent to note that the same idea goes in reverse — if you see 13F filings of an insider buying a ton of stock — you should also put that on your “to buy” radar.
Insider Monkey offers great coverage of these filings.
The third reason to sell a stock is something you can’t just quantify…
3) You don’t trust the company
Sometimes the reason to sell a stock is purely gut instinct.
Do you like this company? Do you understand the company? Are you satisfied with the growth it promised since you’ve owned it? Do you feel like you are being told the truth?
I have owned companies before that haven’t waved a big red warning flag at me. But they slowly chipped away at my confidence: sub-par earnings one week, a key management defection the next, or worse yet — months of no news at all.
Sometimes I just ditch all the technical markers and go with my instinct.
It’s the instinct that is fighting those other instincts that are pleading with me not to sell low, the same instincts that scream at me to hold a position far too long, the same instincts that shout “Don’t be a loser!”.
That is essentially the key to successful investing: being able to control the schizophrenic relationship within your investing mind. That brings yet another Kenny Rogers song to mind. It’s called “I Just Dropped In (To See What Condition My Condition Is In).”
In order to maintain some gravity when taking inventory of your stocks, you need to check in on the fundamentals of your portfolio. This doesn’t mean frantically sweating and cursing your computer screen every day, it means having some basic rules for when you like to own and when you need to sell. In essence, what condition are they in?
You should have enough confidence in your positions — and why you bought them in the first place — to not sweat the day-by-day market returns.
If you stick to a set of principles, you won’t be a mere gambler; you’ll be a full-fledged investor.
Jimmy is a managing editor for Outsider Club and the Investment Director of the personal finance advisory The Crow’s Nest. You may also know him as the architect behind the wildly popular finance and investing website Wealth Wire, where he’s brought readers the stories behind the mainstream financial news each and every day. For more on Jimmy, check out his editor’s page.
