Many investors holding large losing positions in stocks tend to wait till these stock holdings return to their original prices before selling them rather than realizing their losses.
In fact, many investors don’t want to admit that they have made a bad investment. They might feel that if they cash out and realize their investment losses, they are admitting failure.
You must be aware of this fallacy and avoid this as far as possible.
How to identify a sunk cost fallacy
Say for example you’ve bought some of our local stocks over the past few years that have performed really badly because their business models have been fundamentally disrupted.
If you’re an investor who bought them at their high, and is still holding them on dearly or constantly pumping more money to average them down, you might be a victim of the sunk cost fallacy.
Waiting to breakeven is not always the right move
There is no way to tell if the stock is ever going back up again.
Since prices reflect all available public information and future expectations of the company, the trading price of the stock might be what is considered fairly valued based on all available public information.
Unless you know something that the market doesn’t, it is worth weighing the trade-offs of holding a loss-making position and waiting for it to go back up, and freeing up capital for a more attractive investment.
Gains are much harder than losses
A stock that declines 50% has to increase by 100% for you to breakeven. What this means is that it is better to bite the bullet and cut your losses early, than to pray that it will eventually recover to your cost price.
Recognizing a bad investment decision early is one of the most important and critical skills in investing. Once you know that your investment thesis is proven wrong, ask yourself if it’s worth selling at a loss early to reduce further pain down the road.
You should not invest money based on sentiment and emotion, but by a clear and rational decision-making process.
Don’t get emotional to stocks
Never get too emotional with your holdings. Investments are investments, they are there to make you money, not to give you love.
Ask yourself why you invested in the first place, and how long is your time horizon in investing. If the fundamentals of the company have changed, you need to re-evaluate the investment case.
For me, I consider several reasons before I sell a stock.
Set investment goals and stop-losses
Instead, what you can do is to set investment goals for your investments. If this investment is for retirement, make sure that the investment opportunity are set up such that you can endure the volatility of the stock market over the period of time.
If you have a shorter time horizon for investments, make a point to set price targets or stop losses to ensure that you do not exceed your tolerance for capital losses.