FACT: Nobody can make profits every time.
One of the most crucial, but challenging to learn, skills is managing loss. Losses are a constant in trading and investing. When we started trading and investing, we made a lot of blunders and incurred losses. Our losses are exacerbated when we take on speculative, oversized, or leveraged positions.
Good loss management skills are crucial for anyone wishing to trade or make investments.
We need to learn how to reduce losses when our positions are small, as it will be more difficult to minimise the loss when the positions are larger.
A common saying: “Cut your losses short and let your winners run”. Easier said than done. Cutting losses is hard. Pressing the “sell” button can be very difficult to do. Retail investors tend to do the opposite: taking profits first and early and letting losses run. Over time, we realise we are holding many losing stocks with a net loss position. This is akin to having a bucket with many holes. Efforts to make profits are constantly being sucked out by losses. This makes investing/trading tiring and untenable. Hence, it is not just about making money; it is also about managing losses.
Why cutting loss is difficult?
Ego and Hope: I am right and I will be right!
We are often confident with our trade plan/investing thesis. We are optimistic and think of the upside but do not consider the plausible (drastic) downside. When the share price falls below the buying price, we hope it will rebound. The share price may continue to drop.
We can strongly believe that we are right (with conviction and confidence) with our positions but the reality can turn against our expectations. The circumstances have changed and/or we overestimate the capability of the companies we invest in. We find it hard to accept that we are wrong and cut losses. We may self-justify ourselves with reasons to hold on to the losing stocks (affirmative and confirmation biases, sunk cost fallacy). We believe the market conditions will get better and the company is taking longer to turn around. We cheer when there is good news and good price actions. We hope things will get better (one day).
We need to recognise that hope is NOT a strategy. The stocks can be languishing with little probability of turnaround. As investors, we have to be objective instead of emotionally attached to our positions. We need to evaluate critically:
- Are the companies we invested in able to continue to do well?
- Are there better investments where we can redeploy our capital?
Disappointment and embarrassment
We hate and avoid losing money. We would be reluctant to log in to our brokerage account or trading journal to see the losses. By avoiding timely actions, the losses may become bigger and we feel sick and sad looking at these losses. The bigger the losses, the more difficult it is to stay rational about what to do next.
Cannot lose; fear of permanent loss
We do not like to lose. A break-even or little profit will be good. We do not want to sell for a loss. It looks better with profits (even to ourselves and no one else knows). We just want to avoid losses; we have a huge propensity for loss aversion. We are willing to wait to break even (even when the wait can be very long). However, there is an opportunity cost to waiting and the investment may just decline over time as the companies’ financial performance keeps deteriorating over time or worse, it may go into judicial management or bankruptcy.
Anchor bias and sunk cost fallacy
Often, conviction is a function of our buying price rather than the quality of the companies we invested in and their valuation. We have our conviction boosted by rising share prices and profits. Our conviction diminishes when stocks crash and losses swell. Our buying price has created an anchor bias.
Losing positions causes the sunk cost fallacy that our past investments influence our future decisions. Unfortunately, many sell only when they receive margin calls or when they need money. Otherwise, they keep holding to their losing positions.
Volatility ≠ Risk
Volatility is the extent of the swing in share price. A company’s share price can have a wild swing in the short term while it keeps growing. In the short term, it is more sentiment-driven and the market is worried about its future caused by the macro environment, competitive moves and some mistakes made by the company. The wild swings in share price can cause wild swings in our emotions; swing from being happy to fearful and worried. In the longer term, the company has to prove itself as the share price will correlate with its financial performance.
A good post of a checklist for risk: David Gardner’s Step-By-Step System to Measure Risk in the Stock Market
Stage of denial and depression
It is human nature that when the stock portfolio is doing well, we tend to check on the stock prices and profits made regularly, brimming with joy and giving ourselves a pat for a good job well done.
On the other hand, when the stocks keep dropping in value, we lose interest and ignore them. As the losses worsen, we self-doubt ourselves. We become despondent. We stop checking and do not want to know the extent of the drop in profits or losses. We do not want to face the reality. Inertia takes over. Weak stocks are not weeded out promptly and at the same time, we do not take advantage of the pull-back to switch and/or add to higher-quality positions.
The losses become so much (in dollar and/or percentage terms) that we are at a loss and do not know what to do. These are the stages of anger and depression and we have to avoid our losses reaching these stages.
Winners are not afraid of losing. But losers are. Failure is part of the process of success. People who avoid failure also avoid success.
Robert T. Kiyosaki
Be fearful when others are greedy. Be greedy when others are fearful.
Warren Buffett
Growth mindset: Losses as stepping stones and not obstacles
Losses are inevitable. Losses are a natural part of the investment journey. Instead of letting them discourage us, we should embrace them as opportunities to learn and grow. By understanding the reasons behind our losses, we can refine our strategies and make more informed decisions in the future. Losses should not create and accumulate more negative beliefs and biases. Remember, the goal is to become a better investor.
- Losses are a natural part of investing and they can be valuable lessons. Focus on improvements and get better.
- Be prepared that the reality can be very different from our expectations. Do not just think of the upside and forget about the plausible downside.
To be better, we take risks and losses are inevitable. Growth comes at the point of resistance. As we keep improving ourselves to be better investors, we must take risks by trying new strategies and taking on opportunities that others may avoid — losses will happen. We learn by pushing ourselves and finding what lies at the outer reaches of our abilities. Gradually, we improve and expand our game.
Be expected to be surprised. In investing and trading, no matter how much preparation we do, we will always be in unfamiliar terrain and the future is always unknown. Conditions might not be calm or reasonable. Regardless of our experience, conviction and confidence, always be prepared that we can be wrong — our positions may not go according to plan.
The only real mistake is the one from which we learn nothing.
Henry Ford
Every adversity, every failure, every heartache carries with it the seed of an equal or greater benefit.
Napoleon Hill
Things to consider:
- Set realistic expectations: Setting realistic goals can help manage disappointment when losses occur.
- Diversify your portfolio: Spreading your investments across different assets can help mitigate the impact of losses in any particular area.
- Review your investment strategy regularly: Periodically assess your investment approach to ensure it aligns with your financial goals and risk tolerance.
Here are excerpts from a good interview by William Green with Ray Dalio, a billionaire investor who founded the world’s largest hedge fund, Bridgewater Associates, about the 1982 debt crisis where Mexico defaulted its debt that Ray Dalio had to fire everyone at Bridgewater and ended up borrowing four grand from his father:
…. It was such a painful experience, I think and then I really learned pain plus reflection equals progress. That’s one of the principles. I learned that every time I have an encounter that it’s like a puzzle that if I can solve the puzzle, you know, what should I do differently or how should I deal with it, I would get a gem, and the gem would be a new principle in learning that would improve my life.
…. We learn a lot from pain, you know, life I think is, it’s almost a trick. What happens is the second order consequences are so often the opposite of the first order consequences. In other words, the things that are really good for us don’t feel good and the things that are bad for us feel good. You know, okay.
You eat the, you know, the tasty stuff is the stuff that is not probably good for you. The exercise that might be painful is the thing that you don’t want to do, and you want to do the painful. So quite often pain or that is the opposite. It is a trick. Can you do the things that are really good for you? . And so those kinds of reflections I think we are very powerful and our experience really brought a lot of those.
Pain + Reflection = Progress
Take charge; keep scores and learn to improve
If we are serious about making money from stocks, be business owners and treat investing/investing like a business. Be responsible.
What gets measured gets done. A disciplined and systematic approach to tracking how well trade plans are executed and recording every buy and sell transaction is an important first step. Tracking the profit and loss on a weekly or monthly basis forces us to focus on how well we are faring and examine the positions for required actions.
This was what I did and it transformed my investing journey. You can read it here and how it has helped me in many ways: One thing I do that transforms my investment/trading journey.
By keeping track, we will evaluate the quality of our investing/trading skills, and our ability to manage losses. It will be a process of self-discovery and taking charge. Slowly, we will recognise our investing/trading patterns and the weaknesses to work on. As we learn and improve the quality of decision-making and execution, we should be able to achieve better results.
Dealing with losses
There are ways to look at losses and manage them. The Art of Execution: How the world’s best investors get it wrong and still make millions by Lee Freeman-Shor provides several ways to manage losses.
- Do nothing
- Either (a) sell because our investing thesis is not valid anymore or (b) buy more because we still believe in the thesis and the lower prices present a good opportunity
- Cut loss: This applies to both traders as well as investors
How can we improve ourselves?
Learn from our losses constructively; don’t waste the losses.
Profits increase wealth and happiness, losses bring experience.
Failure isn’t fatal, but failure to change might be.
John Wooden
I have not failed. I’ve just found 10,000 ways that won’t work.
Thomas A. Edison
Keep asking 2 questions
Question 1: Will you buy at these prices? Will you wait for lower prices? What prices would you buy?
Question the thesis.
Here, we put our conviction to the test with the declining prices. If we are convinced, we should be willing to add when the price drops. If not, we should trim or cut.
However, this may not work well. Having losses and the sunk cost effect will cause biases that cause us unable to think rationally. We will keep moving the goalposts with our reasons and excuses though the reality is already quite different from our original thesis.
Question 2: Are there better investment opportunities to switch to?
Compare the investing theses.
I find question 2 presents a better approach. It can be a less biased approach comparing the investing theses of different stocks (“comparative” conviction) to make the evaluation process more rational and objective. It allows reducing losses.
A “yes” to the question implies that the investing thesis of the loss-making position has weakened or is not as strong. Switching to a better opportunity can make cutting losses easier. It provides us with the opportunity to turn profitable. For a start, switch slowly rather than switching the entire position for something else.
This has become an important aspect of my investing approach. Always explore to find good investing opportunities to switch out and fill the portfolio with the best investing ideas.
Strong opinions, weakly (or loosely) held
This is my oft-used expression. It is a framework developed by technology forecaster and Stanford University professor Paul Saffo. He described the process as:
“Allow your intuition to guide you to a conclusion, no matter how imperfect — this is the ‘strong opinion’ part. Then –and this is the ‘weakly held’ part– prove yourself wrong. Engage in creative doubt. Look for information that doesn’t fit or indicators that point in an entirely different direction. Eventually, your intuition will kick in and a new hypothesis will emerge out of the rubble, ready to be ruthlessly torn apart once again. You will be surprised by how quickly the sequence of faulty forecasts will deliver you to a useful result.”
It is a useful default perspective to adopt in the face of any issue fraught with high levels of uncertainty, whether one is venturing into a forecast or not. It is about the ability to embrace the power of definiteness and the power of openness concurrently. And when you act, you cannot be of two minds. You have to commit and proceed boldly. But to understand the world, you have to constantly learn, adapt, and grow, which implies shifting direction.
The illiterate of the 21st century will not be those who cannot read or write, but those who cannot learn, unlearn and relearn.
Alvin Toffler
Knowledge is having the right answers. Intelligence is asking the right questions. Wisdom is knowing when to ask the right questions.
Marc Andreessen, the co-founder of Netscape and venture capital firm, Andreessen Horowitz, is often associated with the term. Being a venture capitalist, he is always looking for start-ups with great business ideas that oppose conventional wisdom. These can be very hard to execute, and entrepreneurs must have strong convictions because of the big bet of time, money, or both. However, as the world changes, how will they react?
Be open-minded and humble. Have conviction with flexibility. Be prepared to change and pivot.
Listen to alternative views. We can be wrong with our views. Study alternative views to test our investing thesis to reduce the possible biases that we have.
Check out the following related articles:
What should investors do when markets are crashing??!!
Everyone is different and needs to have their own investment strategy to succeed.
The great investing myth (6): Being right
