Some times it’s helpful to consider the wisdom of the sages for helpful investment guidance. Here’s one that should serve you well, and it addresses a natural behavioral weakness of investors, the reluctance to realize losses.
There are a number of reasons we avoid realizing losses, not the least of which is our unwillingness to admit mistakes. But do consider this profound observation: while a 20% loss can occasionally occur overnight when a security gaps down on some news released after the previous days close, most 20% losses come after a 3% loss and a 7% loss and a 12% loss and so forth. So a good way to prevent 20% losses is to sell securities when the loss is somewhat less than that. In other words, if you realize all your 5% or 7% losses–arbitrary numbers, these–you’ll rarely have a 20% loss. Brilliant, isn’t it?
Anyway, here’re a few excerpts from “an unpublished paper” from 1963 that was published in Classics II Another Investor’s Anthology. The author of the paper was George Ross Goobey. He was a pension fund manager in the 1950s, and according to a paper I found on Al Gore’s Information Superhighway, he “was a pioneer in pension funds investing predominantly in equities.”
There is an old and, I think, misleading adage which runs ‘always take a profit and you will never make a loss.’ As a long term investor I have found it much more profitable to run profits and cut losses.
If I could give clients one piece of advice, it would be to treat a stock more like a factory and consider what are its prospects rather than what was its cost. If cost were the determining factor–and namely whether it is less than the price–then every obsolescent factory would still be belching out coal smoke. Mr. Goobey echoes that sentiment when he says,
What I am really leading up to saying is that in considering whether one should sell an investment it is much better to ignore the price paid and to endeavour to judge the future of the Company on the facts of the situation in which the original cost of your own particular investment plays no part.
And I’m guilty of the following as much as any client, and it takes a lot to override the tendency in which the,
cost factor seems to play the most important part and one is much more ready to sell an investment standing above the price paid for it than vice versa.
The other foible he mentions is one that might even be harder to overcome, and that is the tendency to add to holdings that are at losses, so called averaging down. It’s a Warren Buffett approach that says if you’re an investor you’re better off with falling prices as it gives one an opportunity to buy more shares of a good company. Unfortunately, you are not Warren Buffett, and you do not have his keen understanding of a company’s intrinsic value, nor can you purchase billions of dollars of the shares and get management to drink a Cherry Coke with you. On that subject–averaging down–George Goobey has the following to say.
There is also a type of investor who gets even more keen to buy when the price of a share falls below the price of his original purchase . . . It is a sort of human vanity which cannot admit that the original purchase was wrong and that therefore it must be an even better investment to purchase more shares at a cheaper price.