How to make peace with your stock market losses

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

Looking at our losses won’t make them any smaller. But it might make us feel smaller. And it’s natural to avoid looking too closely at any evidence that might undermine our belief that we are skilled investors. In down markets, however, making good decisions often requires admitting things about ourselves we would much rather ignore.

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

Since the end of March, when stocks were within a whisker of their all-time highs, investors have withdrawn about $80 billion from stock mutual funds and exchange-traded funds, according to the Investment Company Institute.

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

That’s partly because of sheer inertia, partly because millions of people invest on autopilot and partly because changing course when you’re losing money feels intensely painful.

Just about every investor recognizes the wisdom of the old saying, “Cut your losses and let your profits run.” But the only thing worse than losing is having to admit that you’re a loser.

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

Worse, what you just sold could go back up, or whatever you put the money into instead could go down—making you feel like an idiot twice.

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

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

You might buy a stock at $20 and set a stop-loss order at $15, in theory handcuffing your loss at 25%. In practice, however, people can tear off the cuffs: As a stock falls toward $15, they might drop their stop loss, say to $10. If it keeps dropping until it approaches $10, they cut their stop loss again, maybe to $7.50—and so on.

How common is this kind of behavior? In the recent study, 40% of the time the online traders who’d already placed stop-loss orders took any action related to their positions, it was to lower those stop-loss thresholds even further.

The more the prices of their holdings fell, the farther the traders dropped the levels at which they would automatically be forced to sell. Instead of stopping their losses, these traders ended up chasing them. They intended to quit, but they couldn’t.

Surely professional investors are better at selling?

Surely you jest.

New research shows that fund managers lose an average of about 0.8 percentage points of return annually through poor selling decisions. The managers tend to sell either their most extreme recent winners or losers—which, on average, go on to outperform after the funds dump them.

“They could have done substantially better by throwing a dart at their portfolio and selling whatever it hit instead of the stocks they actually sold,” says Alex Imas, one of the study’s authors and a finance professor at the University of Chicago.

To learn whether your selling decisions are any good, you’ll have to track not only the investments you hold, but those you sold. If what you sold is outperforming what you hold, you’ve been selling the wrong investments—something you’ll never learn unless you are willing to look.

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

“Our bias against quitting is really strong,” she says. “When the facts conflict with our feelings, we’ll find a way to ignore the facts.”

One of the best ways to determine whether you should quit is to design, in advance, what Ms. Duke calls “kill criteria.” That commits you to a set of conditions an investment has to meet—or else be sold.

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

Other people might have different reasons for owning bitcoin, but you can’t switch kill criteria after the fact. When your rationale turned out to be wrong, you would have had to sell, thereby avoiding much of bitcoin’s nearly 60% drop this year.

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

Disclaimer: This story has been published from a wire agency feed without modifications to the text.

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