Selling loss-making investments critical to wealth management

Financial Planning | admin | November 4, 2011 at 5:59 am

Many of us think that if we buy the right investment at the right time, we should do well in the long run. That is only half the story. How well we do also depends on whether we are able to sell what did not work for us as expected.

A crucial skill in managing money is the ability to ensure that it is deployed efficiently most of the time, if not all the time. When we refuse to sell what we know to be a wrong investment in the first place, we allow the portfolio to bleed. Why is it tough to sell? First, we are happy with the decisions that make us proud and are unwilling to make those decisions that result in regret.

Behavioural economists have established that the pain from a loss is disproportionately higher than the pleasure from a profit. We can therefore readily sell an investment that made us money, but will postpone the decision to sell that which is already yielding loss. We justify our investment one way or the other, hold on to it with blind hope, or get bitter about having been fooled into buying the wrong investment, but may not act on it. This is even true where fresh action is not called for.

Investors in the wrong Ulip are often eager to sell, close, take the loss and accept they made a mistake in the first place. This is because they tend to reconsider their decision every time a premium is due. They are unwilling to invest more in what they have come to realise is a wrong product. Yet, investors in poorly performing stocks and funds are unwilling to sell and book their losses since there is no new investment to be made.

It is important to review the portfolio and ask if we are holding something that is not good enough to buy now. Perhaps those items need to be sold. Second, many of us have invested emotional capital in the buying decision. This makes admitting to a mistake very difficult.

We like to believe that we have not made a wrong decision and indulge in justifying it. We fall in love with what we have and parting is painful. Investment decisions are based on information available at that time. Subsequent events might alter the attractiveness of the investment. Last year, around this time, many were expecting the next bull run in the equity markets, with the Coal India issue getting very good response from investors.

A year later, mining is full of new risks and unknowns, and several power companies are staring at big losses. If we thought then that Adani, JSW and Crompton Greaves were stars that will make it big, we know today that they are struggling with losses. If we continue to hold them in the hope that they will still be good since we thought they were good when we bought them, we are blinded by our love for these stocks.

Investments have to work hard for us to create the wealth we are looking for. If they are losing money for us, loving them is an emotional mistake. Third, we like to believe that when the market as a whole is falling, it may not be a good time to sell since prices may have fallen due to the bad times.

We like to believe that once the cycle turns, our poorly performing investments will look up too. We like to sit on loss-making investments in this hope. When the markets go through a bear phase, as is currently the case, the price of the good, the bad and the ugly come down. What is important to remember is that poor stocks will lose the most.

A downturn is not just a fall in price. It is the change in business environment, where businesses have to rework their assumptions about how much they will produce, sell, and profit. Stocks of small businesses that went up in investor frenzy during a bull run might be faced with the prospect of failing in the new business environment. It may therefore be more difficult for such stocks to gain when the market turns up.

For example, if a stock, whose peak price was Rs 100 has fallen to Rs 20, it has lost 80% in value. This is higher than the fall in the market. To be able to go back to the earlier price of Rs 100, the stock needs to gain 400%. That may be an unrealistic expectation from a stock battered by changed business realities. Fourth, when the markets go through a bearish phase, truly good stocks could be selling at attractive prices due to lack of overall buying interest. Solid stocks that are highly sought after, such as HDFC, are now available at a 15% discount to their peak prices. To take advantage of such discounts, cash is required and is best generated by liquidating the investments that are not doing well.

Managing the portfolio is about ensuring that it is rebalanced from time to time. If one portion of the portfolio has lost 50% and the other is made up of good performers, it is a good idea to release the cash locked in poor performers. This would not only cut further loss, but redeploy the money at a better rate. It is important to look at the portfolio holistically and ask if reworking the components is in the interest of overall returns.

We can try selling a portion of the investments that is making a loss and redeploy it elsewhere, even if it is a bank deposit. After three months, we can go back to see the price of what we sold and the interest earned on the deposit. We will know that we have managed the portfolio better. It is difficult to sell, especially at a loss, but a bear market offers the best opportunity to recoup some of the losses of the mistakes made in the bull market. Rebalance the portfolio to ensure that the money is not stuck in losers and is re-routed to make the most when the markets turn up.

Source: Economic Times