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Crystallising Losses: When to Sell Your Investments

So you bought shares in a company or units in a fund a while ago, and they meandered along, up a bit, down a bit and now they are down about 5%. Or maybe they’re down even more, say 20%.

What do you do? Do you crystallise your losses and “run” to or to use crypto-lingo HODL “Hold (On for Dear Life)”?

In this blog we’re going to give you some perspective to those 2 scenarios plus a couple of things to think about when contemplating selling shares or exiting an investment.

First, what does a share price actually represent?

As many will know, the share price represents the value of a tiny slice of ownership of the company overall. But it’s actually much more than that. It’s a view of the future.

Collectively someone else must want to buy at that share price to allow you to sell (and the reverse). If for example, a company makes losses for the next few years, but is anticipated to make huge profits thereafter, those future huge profits are worth something. It is the belief in potential.

This potential explains the valuation well beyond the current asset value and even a multiple of sales that companies like Tesla have. Even Microsoft trades at a p/e ratio of about 36, meaning that you pay $36 for each dollar of last year’s “profit” (not paid out as dividends, or even before all expenses). This sounds like a lot but if future profits are higher it makes more sense. Few companies have or predict stable profits, usually promising future growth.

Conversely, a company that indicates it is mature and even in decline, will trade at a much smaller multiple, because the future estimated potential for even greater profits are not there. Further a change in expectation of investors en masse based on company reports, news or even tweets, can jump or crash the price as the investors each re-evaluate the company’s future potential. More on this to come in future blogs.

Consider the influence of Anchoring and Status Quo Bias

Once you’ve grasped what a share price represents, the next step is to call out yourself as a human with all sorts of emotions, fears and aspirations. There are two relevant Behavioural Economics concepts here worth explaining and reflecting on – Anchoring and Status Quo Bias.

Anchoring

Anchoring is a “heuristic” where the start point serves as a reference point and influences subsequent judgments. So, if you bought shares for $10 and the current price is $9.50, you might wait, willing the company good things, hoping that it increases to that all important point where you can avoid a loss (in isolation to that one investment) and the associated psychological pain.

The more you think about it, the more irrational it should appear, but it doesn’t stop it from happening. Just because that was the share price available on the day you bought, it doesn’t affect whether today that it is the right or fair price for someone else to buy from you. But it does for you, and the hard truth is that you will just have to get over it.

Status Quo Bias

Status quo bias is the internal friction you have when you would prefer to stick with a previously made decision. It’s part of the endowment effect where we place a greater value on things we own than those we don’t.

While status quo bias is frequently considered to be irrational, sticking to choices that worked in the past is often a safe and less difficult decision. This can be especially so with investments because of the vast number of alternatives creating what is called “choice overload”.

Overall, it goes back to the granddaddy of research on behavioural biases, Kahneman and Tversky’s Prospect Theory (explained in Thinking Fast and Slow). That is, people feel greater regret for bad outcomes which result from new actions taken than for bad consequences that are the consequence of inaction.

So, what should you do?

There is no easy answer, other than to say it should be changes to your personal life that changes your investments and your strategy, not changes in the market. But that’s a bit flippant for some, so here are some other things to look at.

Understand your risk tolerance and investment horizon

If your horizon is long term (5+ years), be careful you are not trying to “time the market” by switching in and out; between cash and shares or even from NZ to overseas.

Also be mindful that your risk tolerance may be too aggressive for your understanding of volatility. Higher returns are usually accompanied by higher fluctuations but don’t get stuck thinking in reverse that your greater risk needs to be rewarded by a greater return. You are just a passenger to the company activities and economic environment. Almost like you need a better seat belt in a race car than an everyday car because the G-forces are greater. You may also have too much of your investments in high volatility investments which can be exhausting, especially if you watch too closely and feel you need to brace for every corner. There is a lot to be said for setting and forgetting, but if you can’t do that and have the Illusion of Control, maybe limit high volatility investments to 10%.

Look at any underlying reasons as to why the price is lower

If you are invested in individual companies, we suggest looking at announcements of the company on www.nzx.com or the relevant stock exchange. The ones marked with a “p” for price sensitive are the important ones as part of their timely and continuous disclosure of important information.

Remember that boards and executives commonly speak in euphemisms. Skeptics will say they are trying to always put a positive spin on matters meanwhile investors often overreact to news, thinking it is part of a trend. An unprofitable period or some negative news is not guaranteed to continue.

By selling investments you are “crystallising a loss”, and not giving the investment a chance to rebound and the company to go through a better patch with more positive conditions or news. You can be closing the gate after the horse has escaped and not giving it a chance to come back.

Sometimes there aren’t any reasons why, it’s just the Random Walk that prices take based on collective investor sentiment.

Benchmark your performance to a relevant index

You might also try comparing or benchmarking your performance to that of a relevant index or index fund such as the NZ 20 or Global 100. If the “market” is up, down or sideways, this is a systemic effect that shares “tend” to move in similar directions from economic and political environments.

You might find that alternatives would have done no better and overall “beware” of past performance before you start “chasing returns”. This is one of the most dangerous activities individual investors succumb to when choosing investments, be it companies or funds.

The past is no predictor, but the future is looking bright

Remember the investment truism – and what is required by law on most investments – that past performance is no indicator of future returns.

Let’s be absolutely clear, no indicator, as any trend you can see is able to change course or revert to mean, due to a wide range and combination of reasons, from a change in the environment such as interest rates, competitor actions, or things within a company’s control. That is the non-linear nature of investing. Predicting the future and more specifically the actions of other investors in the future is asking for trouble and disappointment.

On a bright note, the long term trend of economic growth is up. So, if you wait long enough and avoid the costs of switching or interfering by investing in diversified funds, you’ll see great results.


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