How to make peace with your stock market losses

If you’re anything like me, your answer is no. You probably already know that year to date stocks are down 20% and bonds are down 14%.

Looking at our losses won’t make them any smaller. But it might make us feel smaller. And it’s natural not to look too closely at evidence that might undermine our belief that we are sophisticated investors. However, in falling markets, making good decisions often requires admitting things about ourselves that we would much rather ignore.

Let’s start by recognizing that laziness can be a choice.

Since late March, when stocks were a hair’s breadth from their all-time highs, investors have withdrawn about $80 billion from mutual funds and exchange-traded funds, according to the Investment Company Institute.

US and international equity funds held $19.3 trillion at the end of March. So even though inflation can’t seem to fall and stocks can’t rise, investors have only taken 0.4% of their money out of stock mutual funds.

That’s partly because of sheer inertia, partly because millions of people invest on autopilot, and partly because it’s very painful to change course when you’re losing money.

Almost every investor recognizes the wisdom of the old adage, “Cut your losses and let your gains roll.” But the only thing worse than losing is having to admit that you’re a loser.

So most investors avoid selling an investment when it is in the red. You can pretend that a paper loss isn’t there or that it will work out later. On the other hand, you can’t recognize a loss without realizing that you made a mistake.

Worse, what you just sold could go back up, or whatever you invested instead could go down — and you’ll feel like an idiot twice over.

No wonder selling at a loss is so difficult and so many people freeze in the face of a bear market.

In a recent study, researchers examined how nearly 190,000 traders used stop-loss orders at an international online broker. These instructions are designed to limit how much you can lose by automatically selling an investment when it falls to a predetermined price.

You could buy a stock at $20 and place a stop-loss order at $15, theoretically setting your loss at 25%. In practice, however, people can rip the cuffs off: if a stock falls towards $15, they could lower their stop-loss, say to $10. If it keeps falling until it approaches $10, they lower their stop loss again, maybe to $7.50 – and so on.

How common is this type of behavior? In the most recent study, online traders who already had stop-loss orders in place took action on their positions to lower those stop-loss levels even further 40% of the time.

As the prices of their stocks fell, traders lowered the levels at which they would automatically be forced to sell. Instead of stopping their losses, these traders ended up chasing them. They wanted to quit, but they couldn’t.

Surely professional investors are better at selling?

Sure you’re joking.

New research shows that fund managers lose an average of about 0.8 percentage points of returns each year due to poor selling decisions. Managers tend to sell either their recent winners or losers — who, on average, outperform after funds sell them.

“They could have done a lot better if they had thrown a dart at their portfolio and sold everything it hit, rather than the stocks they actually sold,” says Alex Imas, one of the study’s authors and finance professor the University of Chicago.

To know if your selling decisions are good, you need to track not only the investments you hold, but also those you have sold. If what you’ve sold exceeds what you hold, you’ve sold the wrong investments — something you’ll never know unless you’re willing to look carefully.

Making peace with losses requires planning ahead, says Annie Duke, cognitive psychologist, former poker champion, and author of Quit: The Power of Knowing When to Walk Away.

“We have a very strong bias against quitting,” she says. “When the facts contradict our feelings, we find a way to ignore the facts.”

One of the best ways to determine if you should quit is to design ahead of time what Ms. Duke calls “kill criteria.” That obliges you to a number of conditions that an investment must meet – or be sold.

Let’s say you bought bitcoin last year believing it was a protective hedge against inflation. Introducing kill criteria would have committed you to something along the lines of: “If bitcoin goes down when inflation goes up, my thesis has been disproved and therefore I must sell if in a period when inflation exceeds 5 at least 25% lose %.”

Other people may have different reasons for owning bitcoin, but you cannot change the kill criteria after the fact. When your reasoning turned out to be false, you should have sold, thereby avoiding much of Bitcoin’s nearly 60% decline this year.

For most investors, buying and holding is usually the right decision. But getting rid of your losers doesn’t make you one.

Disclaimer: This story was published from a wire agency feed with no changes to the text.