AT FIRST GLANCE
, investing seems almost incredibly easy: Research solid companies, take smart risks and collect the profits. If it were only that simple. One of the most overlooked elements is having the discipline to take a loss, a reality in which amateurs and pros must learn to deal with everyday.
Although we rationally know it's a necessity, and regardless of the fact that there are tools such as GTC stop-loss orders that make it easier, taking a loss is anything but. The emotional devastation is usually much worse than the fiscal bite. After all, the money's already been long gone a paper loss is still a loss. It's the disappointment that comes with actually making it real. Even after years in the game, it still hurts.
Why? Most obviously, it's because we've lost money. Nobody buys an investment thinking it's going to drop in value. And because money is a scarce and limited resource, we know that every losing trade sets us further away from our financial goals. Every loser represents dozens or even hundreds of hours of work. And every loss means more of a burden that has to be made up by the winners should any ever materialize. Indeed, in the midst of confirming your own fallibility, which is exactly what taking a loser really is, that can be a difficult confidence to muster.
But more than simply missing the money, taking a loss hurts because you've really lost the time. As investors looking to benefit from compound interest, time is our most precious commodity. When you're young, you're apt to let XYZ ride, because you've got plenty of time for it to come back and even more opportunities to earn more money. When you're young, you've got time to spare.
But long before you get that first gray hair, you probably start to realize that our stint on earth, and especially our investment time horizon, is relatively short. So even if the market has gone up over the last 70 years, what matters to most of us is the next 15 or so. Nobody has the luxury of wasting time on lousy trades.
As diligent investors, we've gone to the shareholders meetings and participated on the company's Yahoo message board. We've pored over the annual report and had the quarterly filings automatically emailed as soon as they're released. We've listened to the conference calls with management and read dozens of research reports. We've invested our money and our time. It's painful to see all that effort go down the tubes with a sell order.
Moreover, we build a fantasy about how a particular trade will turn out, and taking the loss means throwing out that fantasy. We've planned. We've set expectations. To sell XYZ confirms things aren't going to work out as expected, and that's a very difficult reality to admit.
For example, how many perfectly intelligent folks were pounding the table for Sirius Satellite Radio after Howard Stern signed "The Most Important Deal in Radio History" in the fall of 2004. Soon after the stock shot up to $9, and many people believed it could only go higher from there. With shares now priced below $3 things haven't worked out as planned. So now what? If Sirius isn't the media stock to own, then what is? Walt Disney? Something else? Left without a backup vision, it's much easier to simply hold on to the old dream. As the saying goes, "status quo is what you know."
Pie in the Sky
3-year stock chart for SIRI.
The reality is that few times does a losing trade a seriously losing trade totally turn around and become a big profit center. Note that by losing trade, I'm not talking about being down 3% in XYZ and placing a ridiculously tight stop-loss order that's sure to get hit. Rather, the big losers are those names that slowly drip 30%, 40%, 50% below the purchase price. They might stabilize. They might even rally and become less of a loser. But rarely do they turn around completely to become a substantial and meaningful win.
Ironically, many folks who find it impossible to take a loss end up selling later at exactly the wrong time: right as the rally begins. Because they are so unquestionably dedicated to seeing the loss turn into a win, many investors insist that "If XYZ ever gets back to where I bought it, I'll finally get out." In reality, they end up selling it 25 cents above where they bought, precisely before it finally begins the $25 rally they foresaw years earlier. We liked it at $50 once, so when it finally can hold that level why are we so eager to trade it away?
As my mother always says, "life is the story of Plan B." The trader's skill isn't in being able to predict the future but to deal with the present, and that includes learning to let go of trades that just aren't working. The longer we hold a substantial loss, the longer we prolong being able to move on to better opportunities. We blindly hold on because we're afraid to face the truth. Not every investment is the glorious winner we'd hoped. That truth hurts. Addressing it is often the toughest trade there is.
Jonathan Hoenig is managing member at Capitalistpig Hedge Fund LLC. He doesn't hold any positions in Sirius Satellite Radio.>