Everybody loves a winning stock.
Investors enjoy talking about their winning positions but fewer are willing to discuss their losing stocks.
In reality, every investor will have some stocks that are in the red.
Even Warren Buffett, one of the most successful investors in history, has had his fair share of losing investments.
As investors, we need to recognise that we are human, and are not immune to errors.
Instead of shunning these mistakes, you should embrace them as part of your learning journey in becoming a better investor.
That begs the question: when you are faced with stocks in the red, how should you react?
Do you double down on a losing position or decide to bite the bullet and accept the loss?
Here are a few examples of situations where cutting your losses makes a lot of sense.
Sour as a lemon
When researching potential investment targets, there will be occasions when you may miss something important.
Because of this omission, you may inadvertently end up with a lemon of an investment.
Good portfolio management dictates that you should actively weed out investments that do not conform to your investment criteria.
If you have ascertained that the investment is indeed a dud, cutting your losses is recommended and may even be a blessing in disguise.
Lousy businesses tend to continue disappointing, and their share prices will continue declining in tandem with the deterioration in their business.
This may sound familiar: you invest in a promising growth company that has products and services that are in great demand.
However, over time, the company loses its direction and competitive edge.
It starts making poor capital allocation decisions and loses market share to nimbler competitors.
Instead of posting rising profits, the company starts to post yearly declines and may even fall into losses.
Naturally, its share price will also tumble in tandem with poor performance.
This downward spiral is painful, but as an investor, a key consideration is whether these problems are temporary or permanent.
If you assess that the problems are temporary, then it makes sense to either hold on or even buy more of the shares at depressed valuations.
But if the deterioration is structural, the business may not be able to climb out of its rut.
Losing the ability to reverse the decline may be the deciding factor here.
If the business continues to flounder, it makes sense to recognise your losses and deploy your capital into more promising investments.
A change in leadership
Many investors may fail to realise the importance of good management.
Granted, there are businesses out there with models strong enough to withstand inept management, but these are few and far between.
The reality is, if a business is not managed well, it could result in a slow but painful decline.
As the saying goes, no matter how good the horse is, you need a great jockey to be able to win the race.
You need to be wary when companies announce a change in leadership, especially when it involves C-suite management such as the CEO, CFO or COO.
The change in leadership could point to underlying business problems, or it could signal a radical change in direction for the company.
Under the new management, the company may no longer fit your investment thesis.
When such cases arise, it’s strongly recommended that you divest it and move on.
Get Smart: Painful but necessary
Cutting losses in a painful but necessary action in helping you to tidy up your portfolio.
Just like a gardener, there is a constant need to pull out the weeds and nurture the flowers.
Ignoring the losers in your portfolio is a double sin.
Not only are you allowing your precious capital to languish in poorly-performing businesses, but there is also opportunity cost involved as this money could be redeployed to more promising companies.
That’s why it’s important to continuously review your investment portfolio.
Biting the bullet and cutting your losses for the above examples will benefit you in the long-term.
And, it will also make you a Smarter investor at the same time.
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Disclaimer: Royston Yang does not own shares in any of the companies mentioned.