Many investors make themselves feel better by telling themselves “It’s OK, I only lose when I sell. The market goes up in the long-run; I just need to hold on and eventually I’ll get back to break even. Why take a loss now when I can just hang in there a little longer and get my money back?”
This kind of thinking is dangerous to your capital.
The “I only lose when I sell” mentality follows from last week’s blog on “market anchoring”, which is when investors get “stuck” on a price for a security. If they initially believed a stock was worth $60 and therefore purchased at $40, the fixation with either of these values means that come hell-or-high-water the investor refuses to exit until they can get at least one of those prices.
Market anchoring costs investors a fortune in lost capital and lost opportunity. They hold on in the hope that their purchase price will be seen again and stubbornly believe their initial hypothesis about the stock is correct and will be proven to be correct. Whilst they are holding and watching their losses mount, they are also missing out on other trading opportunities which will inevitably come their way.
If this type of thinking sounds familiar to you, it may explain why you are yet to make substantial and consistent profits out of the market. It will also explain why you’re portfolio is littered with dog stocks which are trading at a fraction of their hey-day prices and are going sideways at best.
The reality is harsh, it’s unforgiving, and it’s as plain as the fleas on the dogs in your portfolio! You don’t lose when you sell; you lose the second the share price moves against your initial entry price! This is an inescapable reality of the markets, no matter how much some investors want to bury their head in the sand and pretend it’s not true.
The current price of the security, often known as the market price, is the purest concept in finance. It doesn’t matter what you think a stock is worth, despite your bemoaning the fact that the “market has gone mad!” It is the blatant reality of your current worth in a trade. Take it or leave it, the market price of any security is the best you will get right now. Don’t worry about what the price might be tomorrow or next week – anything can happen between now and then – for the good and for the worst!
Some stocks do recover of course, and some will even surpass their crash lows. In these cases, the investor pats themselves on the back for doing the right thing and hanging on. This becomes vindication for placing their undying faith in the stock in question: “See, clearly the right thing to do in a crisis is not to panic, not to sell out in a frenzy like all of those Nervous Nellies, but to hang in there and trust that eventually the market will come to its senses and realise the inherent value in my stock!”
Certainly, many stocks do come back, however far too many don’t, or don’t ever get close to their peak prices. Some of course, like Babcock and Brown, ABC Learning Centres, and Allco Finance Group disappear altogether. Do the punters still holding onto their CHESS statements for these stocks believe they only lose when they sell? They can’t sell!
Let’s look at an example of how ignoring the reality of the market price and focussing on an anchored price busts the “I only lose when I sell” myth.
Not too long ago, just after the GFC had obliterated the “China Miracle” premium built into mining stocks, many of them were trading at a mere fraction of their boom-time peaks. I was speaking to a new client at one of my Live Data Trading Workshops, William (not his real name!), who took umbrage to my contention that holding on until you break even wasn’t a very smart strategy. He was holding Kagara Zinc Limited (KZL).
KZL, a zinc explorer and producer, was a true bull market darling. It rallied from a 2004 low of $0.80 to a ‘China stronger for longer’ high of nearly $8 in late 2006. William had purchased the shares on the way up around the mid-$4’s, watched his investment double, and then watched it halve again. At no time on the way up was there any reason to sell: ‘The Chinese need zinc and lots of it!’ On the way down there was equally no reason to sell: ‘The Chinese needed zinc yesterday, they’ll need it tomorrow as well! KZL is a premium company. After all, China’s not going to stop growing overnight. This price fall is just temporary!’
When KZL eventually fell back to below his original breakeven price, William was a goner: he now refused to sell, ever. Unless of course he was at least breaking even. Even if it meant going down with the ship, he was not going to take a loss on this one. KZL owed him. Not just the money he was losing now, but the profits he was making when it was up around $8. William believed that he deserved those profits and he wasn’t going to budge until he got them back.
The only flaw in William’s plan by the time I found him was that KZL was now trading around $0.50. In spite of the price William wanted, this was the only price the market was going to give him. This was the reality of his situation.
At $0.50, KZL was nearly 90% below William’s initial purchase price, and a whopping 94% fall from the highs. I began to explain the maths of his predicament:
If you lose 10% of the value of a security, you need to make 11% to get back to break even.
100 – 10% = 90 90 x 11% = 100
By the same token, if you lose 20% of your capital you need to make 25% to get back to break even; if you lose 50% you need to make 100%; and so on as evidenced in the table below:
William had lost nearly 90% of the value of his shares and therefore required KZL to go back up 900% from its present price to simply break even. ‘Not impossible!’ by William’s insisting, but how long might it actually take?
That evening, after day 1 of the workshop, I did some maths on William’s predicament and showed him my findings on day two. The results are listed in the tables below (click to enlarge).
In the first table, I assume that KZL will increase in value by 10% per annum, compounding every year for the foreseeable future. Now this was potentially doable given that the average annual return for the overall market is approximately 10%. We’re essentially assuming here that KZL will perform in line with the market. Note that it would take 22 years for KZL to reclaim the price William had purchased at. William had a few good years left in him, but he agreed it might be touch-and-go over his living long enough to see KZL break even! Perhaps now he was going to concede that the “I only lose when I sell” argument was a flawed one? Never!
In the second table, I bow to William’s insistence that KZL is no ordinary stock. “It’s a fantastic stock! It’s just fallen on hard times because crazy and gutless investors weren’t prepared to back its excellent long term growth story.” In this case I assume that KZL would do twice as well as the market, and indeed every single year without fail. William gets a bit of a reprieve here: it will now take only 12 years to break even. He was pretty confident that he’d at least be around to see that happy day and this gave him some comfort!
In the final table, I allowed for KZL to triple the market’s average performance, every year without fail into the future. William agreed that even for KZL this was going to be a stretch, but was happy to know that if it did happen it would cut his sentence down to just 8 years (with good behaviour!).
When you adjust each of the figures for inflation, the impact of which ensures that even if you do break even in 8 years your dollar is going to worth be 22% less, the time taken to break even is far worse. William began to realise that either losing, or not losing money, was only part of the equation. His stubbornness to take a small and quick loss on an investment meant he faced the prospect of “being stuck” in a dog stock for potentially a decade; of potentially watching and cursing the stock every time he read the Saturday paper to check its progress; and the giant knot in his stomach which grew and grew each time KZL did nothing for another week and the ten other stocks he could have bought went through the roof.
Yes, as suggested earlier in this article, many stocks do come back and go on to make even greater highs again. Surely this is argument enough that one really does only lose when one sells. To counter this argument I remind you of those worthless CHESS statements for Babcock et al. Even for the best stocks which do recover, can you handle the excruciating wait until for years on end? And how many better opportunities to grow your wealth are you going to miss in the mean time? Within this context, market anchoring starts to take on a whole new meaning.
I’ve got a theory for my money. I reckon that once you hear it you’ll want to adopt it for your money as well. Only the best will do. I don’t want to be stuck in dog stocks for years on end just waiting to break even. I want to be in the best trading opportunities the market has to offer at any one time. I want a steady stream of income and to see my wealth growing…and growing!
I don’t care where these gains come from or what the companies I trade in do – I just care about them going in the direction I’ve picked. If they don’t, I give them the boot quick-smart. After all, there are plenty of other stocks out there and I’m not married to my trades. I’ve never taken a romantic walk down the beach in the moonlight with BHP! I don’t love it!
Finally, and the most important thing: I don’t care about what my entry price was. It’s just a number. The market price is a far more important number for building my wealth. It’s the only thing standing between me and finding an even better trading opportunity to stick my hard earned cash on.
Carl Capolingua is Head of Education for Australian Stock Report www.australianstockreport.com.au