Cutting losses can be more painful than you think
Published 3:29 pm Friday, April 17, 2009
Why do stock prices fall?
Various factors are involved, but in a nutshell, prices drop when more people want to sell stocks than buy them.
Conversely, the more people buy a particular stock, the faster that stock’s price will rise. If you’ve studied basic economics and the law of supply and demand, you’ve already got a pretty clear sense of why stock prices move the way they do. And yet while the process sounds fairly logical, the behavior of many investors isn’t.
To understand why so many investors have acted in a way that may be counterproductive, let’s look at consumer behavior in another context.
Suppose a hypothetical couple, Mike and Mary Ann Jones, bought a house five years ago for $200,000. They still like everything about the house, and it is the right size to meet their family’s needs for many years to come.
However, the sharp decline in the housing market has caused Mike and Mary Ann such concern that they decide to sell their house, even though they can get only $160,000 for it.
By selling now, they reason, they can avoid further drops, and when the market stabilizes, they can buy another house in the same neighborhood.
To sum up: Mike and Mary Ann took a $40,000 loss on a house they didn’t even need to sell.
In essence, they were betting that the housing market, against all historical evidence, would not recover enough to compensate them for staying put.
Most people would question the rationality of this type of behavior. Yet many of these same people do the same thing when it comes to investments.
Specifically, over the past year and a half, they have sold investments—even quality investments—that still met their needs for growth, income or a combination of both. And when they’ve sold these investments, they’ve taken losses—sometimes big losses.
Just like Mike and Mary Ann, they thought they needed to sell immediately to avoid bigger setbacks later. Don’t make this mistake.
If you weren’t planning on selling your investments before the market decline, why sell them now, possibly locking in a loss?
Many successful investors hold the same investments for 20, 30 or 40 years—in fact, sometimes they pass these investments on to their children, who also hold them for decades. You may someday need to sell, but do so for the right reasons: a change in your goals or life situation, a need to rebalance your portfolio or a fundamental change in the companies in which you’ve invested.
In the meantime, not only should you consider holding on to the investments that still meet your needs, but you should also consider adding investments while the price is so low, if this move is appropriate for your long term financial goals. This type of behavior takes patience, discipline and faith in our markets—all of which are worthwhile traits to cultivate.