The recent downturn in the stock market, along with the specter of many an investor’s bane — recession — has prompted a slew of investment “advice” from various personalities in the media. The other day I was listening to the Talk of the Nation podcast, and they had guest Stephanie AuWerter, editor of SmartMoney.com dispensing some advice to listeners and callers. Read about and listen to this segment of Talk of the Nation here.
I’d like to talk a bit why some of the common advice you hear from AuWerter and company is wrong.
One of the comments that AuWerter made on the Talk of the Nation segment, and a motto I’ve heard many places before, is “you don’t lose money until you sell.” I think epitomizes much of what I think is wrong with such speakers’ advice.
The idea is simple enough. You gave up some cold hard cash for some stock. At the point you sell that stock, you receive cold hard cash in return. If the cash you received when to sold is less than the cash you paid, then you lost money. Simple enough right? You can’t really say you lost money until you have some money from the proceeds from which to deduct your initial cost.
The implication of this motto is, of course, that as long as you don’t sell your stock below the price you paid for it, you’ll never lose money. But… what if your stock never regains the price you paid for it? Do you never sell out? If you never sell the stock, then you’ve as good as lost all your money (not considering what your heirs might do with it).
“Sure”, you might argue, “the stock is down now, but that’s just temporary. I should wait before I sell out until the price comes back up. It’s sure to return to its previous level (or at least a level of acceptable loss).”
Oh really? You know that the stock price is going to go up? Within your time horizon? If that’s the case, then you shouldn’t just hold onto your stock, you should be buying more of it! You should be buying more stock proportional to your certainty that it will go up.
But that’s not the advice. The advice says only to hold onto your stock… until you sell it’s not a loss. Well, folks, I hate to break it to you, but that’s only true for the tax man.
There is a hidden factor about holding onto those shares that the pundits in the media don’t seem to be explaining. It cuts to the core of the “you don’t lose money until you sell” mentality. That factor is opportunity cost. The money you’re keeping in your shares by not selling now is money you’re not able to put toward other investments. The fact is, you probably don’t know if your stock is going to go up or down for any given month (much less day). If you knew that, you would have sold it before it went down. If you didn’t know to unload the stock before it tanked, then how can you possibly know that it’s going to go back up in any timeframe that is acceptable to you?
This brings us to the other main fallacy behind this advice: the reversion to the mean fallacy, or (hopeful) application of the “Law of Averages”.
Alright, so you understand that “you don’t lose money until you sell” is misleading. You are paying an opportunity cost by not selling when there better opportunities around. However, stock prices are sure to go back up right? Why pull out now when the prices are low, when you could wait a little bit for them to revert back to the mean? If you sell now, aren’t you violating the “buy low, sell high” maxim?
Well, first of all, that’s not how reversion to the mean works for stocks. Of course, the typical disclaimer holds that past performance is no guarantee of future performance. Yes yes, we all know this. But realistically, if a stock was performing fairly steadily before a market drop, chances are it will perform steadily after the drop (assuming no other extenuating circumstances), right?
Well… maybe.
But let’s assume for the sake of argument that that’s true. Let’s say that historically, stock ABC has offered roughly a 10% annual return with relatively low volatility. Then, all of a sudden there comes a broad market drop and ABC loses 10% over the course of a week. There doesn’t seem to be anything particularly negative about ABC… so there’s no reason to believe that its steady performance won’t continue. It was just a general market drop that hit it. You can still expect 10% annual return from ABC going forward.
Re-read that paragraph. ABC lost 10% in a single week. This loss was far outside the normal range of ABC’s typical movement. Reversion to the mean, insofar as it applies to ABC, suggests that the chances of ABC repeating that loss in week 2 are low. It does not mean that ABC is likely to regain a significant portion of its loss, as if it were pendulum. The ‘mean’ being reverted to is not the price of ABC’s stock but its return… that is, the 10% annual return. In other words, you can expect it to take 1 year for ABC to return to the same price level that it was at only 1 week ago.
Now, maybe ABC is still the best investment for you. 10% annual return, after all, might be pretty good, even if you took that 10% hit because of the market. However, your decision should not be based on what you purchased ABC for (except to take into account tax ramifications, that is… you can talk to your accountant about that). Your decision should be based on what your alternatives are. Perhaps the market drop exposed a very underpriced stock that you have good reason to believe will return 20% in a year once the market realizes its underpriced. Now your unwillingness to “lose money” by selling ABC is actually losing you money by not making the money available to invest in the new stock.
The fact is, it very well might be a good idea to hold your stock. But if it is, it isn’t for the reason that “you don’t lose money until you sell” or because the “law of averages” is looking out for you. You should continue to hold your stock if it remains an attractive investment to you. How can you tell this? Well ideally, you have some notion of what you think the stock’s “intrinsic value” is… that is, if you value the stock at $100 and it’s currently at $85 then it’s a bargain (maybe not the best bargain available, but nevertheless…). To value the stock, you need to have some sort of means to calculate that value, such as Free Cashflow analysis, etc.
However, there’s a cruder method that you can rely on before you start crunching the numbers, and its simplicity in no way detracts from its beauty: imagine that you have, instead of the stock you own, the cash equivalent to its current market value (that is, the money you would get by selling it right now); now ask yourself… would you spend that money to invest in the stock right now? If your answer is yes, then you should probably hold your stock; if the answer is no, then you should consider selling it and putting the money into a more attractive offering.
Worry about your “loss from selling” when you’re filling our your tax return. The fact is, you already lost the money the second your stock tanked… your wallet just didn’t know it yet. The quesiton is… what are you going to do with the rest of the money you haven’t lost yet?
