How Do You Know When to Cut Losses?
You may have faced the following situation: You’ve invested some money into a stock, fund, or some other investment. The value has dropped. You feel terrible but decide to hold on to it until it recovers its value. You tell yourself you’re getting rid of it the moment it comes back up.
Some time passes. The value doesn’t come back up. Perhaps it has dropped even further. You’ve tried to avoid looking at the investment but it’s really disturbing you.
What should you do? Well, today I’m going to teach you how to position your mindset so you know exactly what to do, every time.
Let’s start with a simple scenario. You want to invest RM1,000 and have two choices. Stock A or Stock B. You do your research and let’s say you conclude that Stock A has potential to gain 20% whereas Stock B only has potential to gain 10%. We assume the risk level for both are the same. Simple decision yes? Stock A.
Fortunately, this is the only decision you’ll need to make to know what to do in my opening scenario. Let me explain.
If you had invested RM10,000 in some Investment X and it dropped 50% in value, then really, you only have RM5,000 at the moment. The important thing to remember is that the drop has already happened. It’s in the past and you can’t go back in time.
So, looking forward you have two choices. Either keep it in Investment X or move it to something else, which we’ll call Investment Y.
How to decide then? The best way is to ignore the past and look at the situation from the view that you have RM5,000 and you’re looking to grow your money. Which of X or Y do you think would have better potential and performance? Whatever your answer, put your money there.
A good way to wrap this mind exercise up is to consider it from another angle. Say again you’ve invested RM10,000 in X, lost 50% down to RM5,000, and have now decided to pull out of the investment once it recovers its value.
What you’re really saying is that you want to take your money out of investment once your RM5,000 grows (back) to RM10,000 right? Well, do you think Investment X or Investment Y has a better chance to grow that RM5,000? If you answer Y, then you should cut losses on your Investment X and move it to Y. However, if you think Investment X is still superior and has the better growth potential, then you should keep it in X.
In psychology, this issue is commonly referred to as the sunk-cost fallacy. We as humans naturally form emotional attachment to things, such as the value of our money in the past. Unfortunately, once time has passed, that value no longer exists and is a ‘sunk-cost’. Always view your investments in the present and you’ll know when to cut losses.