Red. You’ve bought a stock you thought will do well and now you’re five, ten, maybe even twenty percent down. You look and your portfolio and think to yourself. Shit… what do I do? You’re faced with 3 choices. Cut your loss, average down or just hold the stock and pray that it recovers.
Let us Pray
Most investors struggle when making this decision. They don’t know what to do. Coming to terms with a 20% loss isn’t easy. It’s been scientifically proven that humans are more badly affected by a loss than positively affected when they win. Or they would prefer not to lose than to win. For example, most people would rather not lose $5 than to get a $5 discount. So if you put a thousand into that stock and you lose 20% of it, that’s $200, which is a lot for people who just started to invest, you’d feel terrible. These overwhelming emotions impair your decision making and most people would decide to stick with their investment with the hope that it will go up.
I’ve heard a lot of people say that if you’re losing money from a stock it’s only a paper loss and the loss is only realised when you sell it. Although this is true, it probably isn’t the mindset that you want to have, because there is a very realistic chance that the stock will never recover. If that happens, you’ll just have a considerable sum of money stuck in an asset that isn’t going to give you back any return. That’s why most traders believe that cutting loss is the best way to deal with it.
Too bad, let’s find something else
Traders like to play with probability, their system works if more than half of their trades turn over a profit. But they can increase the probability of winning a trade by setting their profit target at a higher percentage than the price they would sell at if they were to incur a loss. (Forgive me for the overly simplified model) Let’s say, a trader put $1000 into 10 trades where he wins 6/10 trades. His profit target is $100 and he cuts loss at $100. His expected return after his 10 trades will be $200. But if he decides to change his stop loss (automatically set sell point if he makes a loss) to $50. Then with the same probability, after 10 trades he can make $400! Twice the amount as just now. So traders basically always set a price where they will sell at a loss so that they can take out the money and try the probability again. As a normal investor, you can also learn from them by setting a point where you will cut loss. Then use that money to invest in a place where you will achieve better results.
But, what if the original stock goes up again?
You should either, as most traders do, ignore it and move on or average down.
Averaging down: Catching the right end of a falling knife
Averaging down is a well-known concept amongst investors through the rationale that if you put more money into a losing investment you minimise the percentage loss and it is easier to recuperate your losses if the stock goes up. But if it goes down, you’re in twice the shit that you were already in. A lot of traders like to say that averaging down is like catching a falling knife. It is true. If the stock never recovers and continues its downward trend. You’ve just royally f***ed yourself over. You’re losing 20% of your $1000 investment. You put in $1000 more because it averages down your loss to 200/(1000+1000) *100 = 10%. If the stock goes up 10% you’re sorted! But if it goes down another 10%, you’ll be down $380. (If 20% then $560)
So is averaging down always a bad idea? No. Some of the best investors encourage buying at new lows. These investors are known as value investors because they’re always there to get a big discount on their investment. They make sure they do their research and only buy shares that they believe to be undervalued. As Warren Buffett describes it, it’s like buying a dollar for fifty cents. In the short run, the market may price the shares at much lower or higher levels than they are actually worth. However, in the long run, stocks generally revert to the mean and get priced back at their true value. So when the stock goes down these value investors get really excited and will keep buying the shares at these depressed levels with the knowledge that they will eventually make money off the stock. So how do you make sure you’re not catching the wrong end of the knife? Make sure to do your research to find out why the share price is falling. These are some questions you might want to ask yourself: Is it because the general market is becoming softer? Is the cause of the problem going to affect the company forever? Is the business model becoming irrelevant?
If you believe that the company is still a good investment. Then you can average down to get a better discount or just leave it because you know that eventually, the share price will recover. Do not base the recovery off the stock’s fluctuations but on the basis that the company still has a strong business model that will continue to do well, otherwise, you may catch the wrong side of the falling knife.
In summary, if you don’t know what to do, find out why the share is doing badly. If the damage to the business model is permanent, cut the loss. If the business is solid and the damage is temporary, buy more and if you don’t have the money to buy just hold it.
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