“Letting Go of Losers”

In the investing universe, there are winners and losers every day. When a trade a occurs, there’s a buyer and a seller. The price movement will determine who won the trade. Price moves up, the buyer wins and vice versa.

That doesn’t mean there can’t be more long-term winners if they do things right. Long term winners are very likely short-term losers, the difference being that winners reduce mistakes. Winners turn short term losses into long-term wins. The ability to emotionally think ahead keeps the winners invested and allows the magic of compounding to take effect.

A common bias in investor behavior is the disposition effect where investors will sell winners and hang onto losers. The idea being that we lock in gains when we get them and hang on to losses because fortunes will turn.

This might be a good strategy if “reversion to the mean” always holds true. Sometimes losers keep losing and winners keep winning. Look at GE versus Apple over the last 12 years. It’s an extreme example and I’m benefiting from hindsight here but there were countless times where I’ve heard that “Apple was up 2x and it can’t go higher”. This was in 2011. Readers will also remember my conversation with the ex-GE employee.

There’s also risks with holding on to Apple under the assumption that it’ll go to the moon. A red flag is when you talk to any “true believer” of any investment, they sound like they’re in a cult.

You might be thinking that I’m telling you to invest only in winners. I wish it were that easy. Sometimes investors become convinced that perpetual winners are unbeatable and start increasing their concentration. See Enron and its former employees.

I was watching a finance reality show (yes, I do that…) where a guy helps people can climb out of debt, start saving, or find a better job, etc. Quick note: personal finance personalities hash out overly generalized advice. Your personal situation may not apply. There was a couple that needed help because they were chasing the latest fads in multilevel marketing and meme stock trading. The husband had a Robinhood account where he made a killing (on paper) with Draftkings stock. Draftkings, like many stocks in 2020, had hypercharged returns in 2020 but very poor performance since early 2021.

Guess where the husband’s mind was at. He is obviously holding on for a rebound with wildly unrealistic price targets after losing $80k.

Trying to understand his mindset, as with the chart above, Draftkings did reach the moon but came back down to Earth. Since it’s been there before there is a world where the stock can reach those highs again. That world requires another catalyst that would garner the interest of millions of new investors. Whether another world changing event like the pandemic will come around again is not impossible but improbable. He could hit the lottery again but that’s the problem with that kind of thinking. It’s a gambler’s approach to investing.

He's seeing the $80k loss as something he needs to get back with that specific stock in a short amount of time. If he sells and Draftkings shoots back up, I can only imagine the amount of regret he’s going to harbor.

The amount of potential regret is coloring his ability to think about it logically. What’s occurred in the past is in the past. There’s nothing to suggest that the future will be anything he expects or hopes for.

Locking in the loss by selling the loser has tax benefits. An $80k loss can offset future gains or $3,000 of it can be used against earned income to reduce tax liability. Any unused realized losses can be carried forward indefinitely. Instead, he’s sitting on an asset that can go down further with a loss that isn’t recognized by the IRS.

How many of us had a similar experience coming out of 2020? We all thought we were investing geniuses because everything from Peloton to Pinterest did nothing but go up. The real question is the ability to move on. Do you still hold these stocks in your investment account? The key is to be able to assess the business outlook for each company. Peloton would need to be able to grow subscribers in an era where no one wants to stay in anymore. Some catalyst would need to happen for interest to pick back up.

It can be hard to decouple emotions from our investments because it’s money. With money, our aspirations or dreams are tied to how much we have. Loss harvesting in a down market is a silver lining for taxable investors.

Short term winners could develop one of the most dangerous mindsets. Day traders in 2020 thought they were invincible, and they have chased those highs since. This behavior can lead to lost fortunes and create bubbles.

This post is not a recommendation to buy or sell any specific stock!

DISCLOSURES:

The information provided is for educational and informational purposes only and does not constitute investment advice and it should not be relied on as such. It should not be considered a solicitation to buy or an offer to sell a security. It does not take into account any investor's particular investment objectives, strategies, tax status or investment horizon. You should consult your attorney or tax advisor.

Generally, among asset classes, stocks are more volatile than bonds or short-term instruments. Government bonds and corporate bonds have more moderate short-term price fluctuations than stocks, but provide lower potential long-term returns. U.S. Treasury Bills maintain a stable value if held to maturity, but returns are generally only slightly above the inflation rate.

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