Daniel Kahneman, Nobel Prize-winning economist, conducted an experiment on his students:
The terms of the experiment were simple… The student would flip a coin. A flip landing tails-up would represent a loss of $10.
Kahneman then asked his students just how much they’d need to be able to win on a heads-up flip to make up for the risk. The typical answer was over $20—more than twice the amount they risked losing.
In other words, only a promise of larger reward could overcome the fear of losing $10…
This concept—called loss aversion—is familiar to most investors.
Kahneman (a leading authority in loss aversion and behavioral economics) estimates our hatred of losing is twice as powerful as our love of winning.
At its worst, the fear of losing money can serve as a powerful motivator to not invest in the stock market at all.
We’re also most reluctant to buy when the market is weak (and our fear of losing is strongest). This sentiment tends to change when the market rallies… pulling more investors from the sidelines. And this tendency to “chase performance” often causes markets to overshoot.
The fear of losing can also overwhelm our logic when making a decision to sell a stock at a loss.
Having a set of rules can help keep you from making fear-based decisions…
Rule No. 1: Know your investment
When fear sets in, it’s extremely helpful to remember why you invested in a stock (or sector) in the first place.
Do your homework and keep up with your research.
There’s really no substitute for this step. If you’re an investor (as opposed to a trader), you can’t rely on technical analysis for your final decision.
If you understand why you’re in the stock, it will be easier to determine whether to sell it, be it for a profit or a loss.
Also, make sure to always keep the big picture in mind.
Compare the stock’s valuation and its price action with those of its peers, the overall market or its sector. No stock exists in a vacuum, and nothing is immune to prevailing market conditions.
Rule No. 2: Watch out for changes in the story
The best single rule for selling a stock—whether for a gain or for a loss—is to exit when the underlying story changes.
This rule works in conjunction with the first rule.
If big news hits, and a stock rallies, you should be able to tell whether you expect even more… or if the time has come to take the gain off the table.
Bad news (like disappointing earnings or a product delay) could cause a stock to sell off—but not change its long-term story that much. If that’s the case, you might want to add to your position on the dip—thereby lowering your cost basis—rather than take a loss.
Watch for management changes, too. The future of nearly every company is defined by the people at the top. If they leave without a good explanation, are forced out, or suddenly retire, it can signal a high level of business uncertainty… more volatility in the stock price… and a potential story change.
Ask yourself if you would buy this company today, with everything you know, at today’s price.
If the answer is “yes,” you should hold on or even add to the position.
If the answer is “maybe,” consider taking a loss. Your final decision might depend on the holding’s valuation… the size of this position in your portfolio… or whether you own another similar position.
And if your answer is a definitive “no,” the best course of action is to sell.
Rule No. 3: Take advantage of your losses
Losses can be valuable when tax season rolls around.
In a taxable account, your losses will help offset your investment gains for the year. And if you have more losses than gains, you can claim up to $3,000 in capital losses every year. (The max is $3,000 for taxpayers filing jointly vs. $1,500 for single filers.) In other words, you can reduce your ordinary income for the year, which directly lowers your taxes.
And, as the law stands now, you can carry forward your capital loss to use in future years (if they’re above the $3,000 cap in a given year).
Keep in mind, tax laws often change—make sure to check with your tax professional to get the timeliest advice.
Plus, even after you’ve booked a loss, you can always buy the stock back at some point in the future.
Just remember the wash sales rule: In order to get a tax-loss benefit, you must not have owned the same or “substantially identical” security within 30 days before or after the sale on any of your accounts.
Wrapping it all up
If you didn’t sell a big loser when the loss was still small, don’t despair. It doesn’t matter what happened yesterday. The market gives us a new, updated picture every day… along with fresh opportunities to buy or sell.
Stock market investing requires patience. Most importantly, it rewards those who have a sound plan.
If you have a long-term plan and follow the three simple rules above, you’ll find it easier to overcome the fear of losing. It’s an important step in becoming a better investor.
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