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Many investors joke that the first rule of investing is “don’t lose money”. Will Rogers famously said, “It is not the return on my investment that I am concerned about; it’s the return of my investment”. Those are two of my favorite investing jokes, probably because they both address the same topic, which is protecting your initial investment, and both have the same punchline.
Everyone always gets worried about what stock to buy or what stock to buy next, but in all of my experience with trading stock, my biggest problem has always been trying to figure out when to sell.
Buying is easy, all of the risks are in the future. Selling is hard because if you lose money, you have to bite the bullet and take that loss. But, it is also hard when you’ve gained money because it’s very easy to get greedy as my friend, Eric Burnside, on Public asserted after doubling his money.
“@arbitrage as a new active investor this holding has put me in the predicament where one stock is getting to be too much of my portfolio… so I need to figure out how much to trim back. I’m realizing how easy it is to get greedy with this”
https://public.com
It sounds crazy but I think it’s harder to sell a stock that has performed very well. I think it’s harder to sell the stock that lets you make gains than it is to sell a loser. People hesitate to sell a losing stock because people hate losing money. But as crazy as that sounds, some people never even think to sell a stock that has gained money.
Why sell a winner?
In most instances selling a winner can feel counterproductive, but that’s only if you are thinking of your temporary stock gains as permanent, which they are not. No individual security is a golden goose and no investment can ever be a sure thing because for something to truly be an investment, there has to be a certain level of risk.
Investing without risk is called saving. In both saving and investing, the more risk you take, the higher the reward. Investing without a calculated amount of measurable risk is called betting.
Betting is generally a zero sum game where the winners and losers are clearly defined. When you invest, the winners and losers are less clearly defined because when you invest, it’s completely possible to lose money while making profitable trades, thanks to taxes and brokerage fees. It’s also possible to gain money from your losses, thanks to tax loss harvesting and complicated investing activities such as tax write offs, covered calls, and investment hedges.
Selling a loser is like putting a tourniquet on a bleeding wound before you eventually bleed to death. Selling a winner, on the other hand, takes a little more effort and mental processing. If individual stocks were sure things or guaranteed to rise forever, selling would never make sense
After you get over the emotional and psychological barriers, deciding to sell a loser is a “no brainer”. From a logical perspective, selling a stock is easy. As soon as you do it, you immediately prevent all future losses and are able to put that money to work again in a better investment where it can actually gain value.
Three key terms
- Unrealized Gains: “An unrealized gain is a potential profit that exists on paper, resulting from an investment. It is an increase in the value of an asset that has yet to be sold for cash, such as a stock position that has increased in value but remains open.”
- Downside Risk “is the estimation of a security’s potential loss in value if market conditions precipitate a decline in that security’s price. The downside risk is a general term for the risk of a loss in an investment”
- Opportunity Cost “is the forgone benefit that would have been derived from an option not chosen.
Putting it all together
Human beings are very bad at predicting risk when it comes to financial situations, especially in the case of gains. When the subject of risk comes up, most people only think about the possibility of bad things happening and not the risk of good things happening.
The exact opposite happens when you are in a good situation, our natural response is to assume that our stock, luck, and good fortune will go on forever. We are more likely to say “if it ain’t broke don’t fix it” or “don’t mess with the winning formula” than we are to say “take the money, never have to run” or “quit while you’re ahead”.
So when it comes to stocks that have performed well, we are less likely to sell those gains because all of a sudden we become more fixated on the upside risk than we are on downside risk. Upside risk refers to the possibility of “what if I quit or sell now and the stock continues to rise without me?” or “what if I sold too early?”
Opportunity cost is another thing that we forget about when thinking about risk. Instead of taking the money, we are willing to risk losing all of our gains just because it’s possible to gain more. The whole time we are trying to squeeze more gains out of a winning position or favorable outcome, we forget about all the other options we have.
Investors do this very often, they will make 20% to 50% gains and will be still preoccupied with future gains from the same investment that they are ignoring all of the other possible investments that they are missing out on, even after they have made money in their current investment.
Opportunity cost is simply the realization that you can’t be in two places at once or that you can’t invest the same money into stocks at the same time, you have to make a choice. When you make that choice, you are simultaneously choosing one opportunity over the other. It’s impossible to decide without passing up at least one opportunity.
When you make gains on an investment and you decide not to sell that stock, you are deciding not to realize your gains. You’re deciding to keep the money you invested locked away. You’re also choosing to keep your profit locked away inside of your investment.
The opportunity costs associated with keeping your principle and your profit locked away is the possibility that you could lose both but more importantly, you have decided not to take that money and put it elsewhere where it has a better chance of growing.
Nobody knows what a stock will do tomorrow, so by selling, you may miss out on future gains but you may also unlock the potential value hidden inside your current investment.
By taking your gains, you avoid a situation that author, Andrew Tobias, calls “picking up pennies in front of a steam roller”, where investors get crushed while trying to squeeze a few more cents out of an investment.
Assuming that you already made money, wouldn’t it be wise to take some (or all) of those gains into a new position where your money had more potential to grow, rather than risk those gains while waiting for a few more percentage points of gains?
Stocks are not governed by the laws of gravity so nothing says that a stock has to fall from its high; however, wouldn’t you sleep better knowing that IF that stock falls, it won’t wipe out all of your gains or possibly eat away at your principal leaving you with less money than you started with?
⚠️This is not investing advice this is my own opinion.