Building Wealth Doc's note: Today, we're finishing up our week of timeless essays on the best ways to maintain both your wealth and your health with a topic that's tough for investors, new and experienced alike... Your success isn't just about how well you make money, but how well you lose it.
"I like to win, but I hate to lose."
Whether it's sports or investing, this is a phrase you've probably heard.
But this type of thinking is a costly mistake.
This is known as "loss aversion" – the idea that losses have a larger psychological impact than gains of the same size.
We hate to lose. And folks especially hate to lose money. Sometimes it drives us to leave money on the table.
In a study by the DrKW Macro research firm, 300 fund managers were offered the following hypothetical bet: On the toss of a fair coin, you must pay £100 if you lose. Researchers asked them the minimum amount they would need to win for this bet to be attractive.
In a perfectly rational world, even just £101 would make for a good bet (if you could make it repeatedly).
But the fund managers wanted almost double that... an average of £190. They weren't willing to risk a loss unless the money was far in their favor. It turns out, people dislike losses about twice as much as they enjoy gains.
This applies to investing as well...
We've all held a stock that's headed down. And we've all – at some point or another – kept holding, hoping to get even: "If it could just get back to my buy price, I would sell and move on."
That whole time, you've got your capital tied up in a stock that the market has soured on. Meanwhile, other stocks are shooting up left and right.
Believe me, the dollars you earn by "getting even" are no more valuable than the dollars you'd earn by switching to the stock of a better business.
You should cut your losses and move on... But many investors simply can't do that.
Folks become emotional with stocks that turn into losers.
It's not just you. It's built into our brains. It's hard to let go.
In a seminal study by Terrance Odean of the University of California, Davis, an analysis of 10,000 individual brokerage accounts found that investors held losing stocks for a median of 124 days versus a median of 102 days for winning stocks.
We're too quick to sell winners lest we give back some of our gains. And it costs us money.
Good investors have to stay rational in the face of a down stock... But we're humans first, investors second. We simply can't be trusted to keep our emotions in check.
That's why we use stop losses.
A stop loss is simply a predetermined price that tells us it's time to sell. For example, you may decide to sell a position if it drops 25%. We typically use trailing stop losses that adjust higher as the stock price rises. That protects more of our gains.
The key is to set your stop when you open a position and honor it when the stock declines to that price.
As soon as we hit our stop, we sell. No questions asked.
If you stick to your exit strategy, it can serve as a near-foolproof way to methodically cut your losses and let your winners ride.
This is easier said than done, but you have to know when to cut your losses.
Emotions make cutting your losses so hard to do. That’s why I usually recommend investors use some sort of exit strategy. Stop losses are a wonderful tool for combatting the sunk cost trap.
And it's why I hope you watched last night's Recovery Investing Event where Whitney Tilson discuss exactly what he sees in store for investors in the coming months.
He explained how a small group of our readers who actually knew that the crash was coming… And how many were able to sell their stocks and lock in profits weeks before the market bottomed.
He also detailed a way of timing the markets that is so precise, it would have alerted you to sell your stocks weeks before the crash.
If you missed the Recovery Investing Event, you can watch it – for a limited time – right here.
Here's to our health, wealth, and a great retirement,
Dr. David Eifrig and the Health & Wealth Bulletin Research Team
May 29, 2020