When building a long-term equity portfolio, one common mistake that many of us make is to watch over our profit-making stocks with tender love and care, while orphaning our loss-making stocks. This, over time, leads to our portfolios featuring a few big winners but carrying a long tail of loser stocks that are down 80 or 90% from their buy price.
If you are prone to this mistake, this article discusses one method employed by smart investors to rein in this problem. Why not set a stop-loss for your fundamental equity holdings to contain losses before they become a dead-weight?
Perils of loss aversion
Behavioural finance experts tell us that ‘loss aversion’ is hard-wired into our brains. Most of us experience far greater pain from a 20% loss than we rejoice at a 20% gain. In equity investing, this impels us to avoid converting the notional losses that we see in our portfolios into real losses by exiting loss-making positions.
Our tendency to convert bad stock bets into automatic ‘long-term’ holdings in the hope that they will bounce back one day, often costs our wealth creation dear. Many Indian investors who have been in the markets for a dozen years, today have portfolios that still feature 90-95% losers like Suzlon Energy, Lanco Infratech, Reliance Power and Jaiprakash Power Ventures.
These holdings tend to act as a dead-weight on portfolio returns, even as more recent stock picks work hard to deliver gains. Investors would have surely saved a packet, found better uses for their money or transformed their mediocre portfolios into great ones, by cutting losses on those earlier-era favourites when they were still only 20 or 30% down.
The other, and even more serious problem with loss aversion is our tendency to throw good money after bad, by averaging stocks that are headed steadily south. Many a retail investor has doggedly averaged a stock on its downhill journey over the years, only to end up with a mega position in a penny stock.
When it comes to exiting bad bets, the sooner one can do it, the better. After all, to recover from a 20% loss from one’s buy price, a stock needs to bounce back only 25%. But to climb back to par from a 50% fall, it needs to double!
A stop-loss strategy
Yes, in an ideal world, if you are a true fundamental investor who bought a stock after a lot of due diligence, you should not worry about a stock price falling. You must in fact accumulate more of a stock the cheaper it gets.
In real life though, such high conviction levels on a stock exist only on rare occasions. Plenty can change in a business after we buy into it based on thorough due diligence. The prospects for the sector can change dramatically, new competitors can crop up to threaten growth and profit metrics and regulators can interfere to change the ground rules for the business. The company’s promoters or management may also suddenly turn rogue on governance. In all such cases, our initial investment thesis on a stock can go awry. Macro factors such as interest rates or liquidity that made a certain valuation acceptable when we bought the stock, may also no longer be supportive.
…being pragmatic about cutting losses may help more than being dogmatic about hanging on and averaging.
All this apart, we also need to admit that none of us is omniscient. We may have been plain wrong about our initial understanding of the business, missed out on critical information or got caught up in bullish sentiment to become too optimistic about a stock’s prospects. In all such cases, being pragmatic about cutting losses may help more than being dogmatic about hanging on and averaging.
Having wrestled with loss aversion myself, I recently raised a query on a Whatsapp group of very seasoned investors down South to get some responses. Should fundamental investors have a stop-loss for each of their stocks? If yes, at what price level should they set this stop-loss?
The responses, from investors who’ve spent a couple of decades or more in markets, were illuminating. This is what they broadly said.
- Set a desirable valuation to buy: When it comes to losses, prevention is better than cure. Therefore, it is best to not jump in to buy a good stock as soon as you identify it. Set a desirable valuation for your purchase and wait patiently for markets to get to that price.
- Don’t buy in one shot: Even if the current price appears okay, never acquire more than 60-70% of your intended position at this price, instead wait until markets give you a better opportunity to buy the rest. This is especially true of bull markets when the FOMO of not owning a good find can be high.
- Set stop losses: Given that we can never have all possible information about a company or a stock while buying it, it is better to admit to being wrong when a stock falls too much from our buy price. It is a good strategy to set stop-losses even on fundamental equity bets to avoid becoming wedded to loss-makers. Unlike short-term traders, who may prefer tight stop-losses of 5-10%, the stop-loss level for fundamental holdings can be 25-30% below one’s buy price. Sell at least part of your holdings if a stock tanks 30% below your buy price and honestly review your initial investment thesis.
- Be wary of averaging: When a stock falls this much, don’t blindly average. It is better to admit that either our buy price was too high or that our initial understanding of the sector or company was wrong.
- Market fall or isolated fall: A price decline associated with a broader market fall, as in March 2020 may be an opportunity to accumulate more of it, but beware of an isolated fall in your stock or sector alone as the markets may have information you don’t.
- Don’t go overweight: Finally, if you are sure that it was your entry price that was at fault or that the market is mis-reading the business and you know it better, consider averaging a falling stock. Even then, make sure you don’t exceed your preferred portfolio weight of 5% or 10%. Pay attention to dividend yield (equal to or higher than risk-free rate) to gauge if a stock is close to bottoming out.
How to make the exit less painful
While setting a stop loss 30% below your buy price is the easy part of containing downside, acting on it and actually selling a loss-making position is a painful decision.
When we are forced to sell a stock below its buy price, we are actually forced to admit we made a blooper buying it in the first place.
Here are a few ways in which you can reduce the pain associated with such exits.
# 1 Don’t go public
One of the behavioural reasons for loss aversion is that none of us like to admit to our mistakes. When we are forced to sell a stock below its buy price, we are actually forced to admit we made a blooper buying it in the first place. Admitting to mistakes or mis-judgements is much harder if you have a bunch of folks watching over and judging what you do. If you are fond of boasting about your winning stocks to your friends and relatives or in the social media, confessing you made a mistake later can be doubly difficult. Therefore, keep your stock holdings private. If you’d like to discuss them with mature, like-minded investors, avoid taking too much credit for winners.
# 2 Write down the thesis
When a stock is languishing below our buy price, understanding why it is underperforming can help us arrive at a sell decision more easily. Gauging if we’ve been completely wrong about a business is easier if we don’t just rely on our memories to assess why we bought a stock. Writing down the investment thesis can help us gauge if it is just market perception or a fundamental change in the business is undermining it. This helps to make a rational decision on exiting it or building conviction to add more.
# 3 Consider a switch
When selling a loss-making stock, it is easier to push yourself to act if you have some hope of making up the losses through another stock pick. If you’ve identified a stock where you’re rapidly losing hope of ever recouping your investment, hunt around for similar priced alternatives from the listed universe that offer a better investment proposition at that juncture. Switching from one hopeless loss-maker to an alternative stock with superior prospects is a feel-good decision to make compared to just selling at a loss.
# 4 Harvest capital losses
One thing that gives most of us Indians a thrill is depriving the taxman of some part of his yearly pound of flesh. With equities in India subject to capital gains tax from 2018, we are obliged to pay capital gains tax at 10% on long-term stock market gains that top Rs 1 lakh a year. This new tax has also had the happy effect of making capital gains losses from equities eligible for set-off and carry forward provisions. Therefore, if you book short term losses from selling stocks in any given year, you can set it off against gains from other stocks or other capital assets to reduce your tax outgo. It can also be carried forward for the next 8 years and adjusted against future gains. Long-term capital losses from stocks too, can be set off similarly against long term gains from other assets. Unabsorbed losses can be carried forward for 8 years to reduce long-term capital gains tax in future years.
Do use these friendly provisions to make sure that you periodically weed out the dud stocks in your portfolio every financial year. Admitting to mistakes need not always pinch your pocket!
Our earlier article in this series: https://primeinvestor.in/sips-in-stocks-should-you-go-for-it/
