Monday, December 31, 2007

To Cut or Not To Cut

In Value Investing, you NEVER cut losses. If you have analysed the company and have determined that it is a good buy, and you bought it. If it goes down, you should be buying MORE of the stock. Since it is cheaper now. Well, that's provided everything is still the same since the time you did your analysis.

But for most novice investors, including this blogger, our analysis is usually flawed. There is probably something that we missed. Remember the market is not stupid. In fact we all know the saying don't we, "The market is always right." If you bought a stock, and it falls 20-30%, chances are something is wrong with the company, at least in the next few mths (well the market is very short-term focused also). And it pays to redo your analysis.

Well if you are willing to wait out the storm (which may take years), then all is well, it may go down 20-30%, but eventually it will come back, and it will surpass your cost price, in time. If you are a true blue value investor, and you think the co. fundamentals have not change when you decided to buy it back then, and if you got the GUTS, then BUY MORE of it.

For those not so true blue value investors, well you may want to follow some trading rules, ie to cut loss at a certain level. Some recommend 10%, some 15% below the price you bought, depending on how much pain you can endure. Hehe. But remember the tighter the cut loss level, the easier it gets triggered and the easier you get whipsawed. Btw whipsaw means you sell after the stock tanked 15% and then it goes to rally 100% and you go and bang your head on every wall you see.

Cutting loss is actually also rational in some ways bcos you can buy more of the stock at a cheaper price. If the stock is now $10 and you used $1000 to buy 100 shares. It drops to $5. And you use another $1000 to buy 200 shares. So you have 300 shares.

But if you cut loss when it drops to $8. You get back $800. It drops to $5 and you use the original $800 plus another $1200 you get to buy 400 shares! In both cases, you spend $2000 but if you cut loss and buy back at a lower price, you get more shares!

Having said that, it is not easy to cut loss bcos of the psychological factor. This is well studied in behaviour finance. People tend to hold on to their losses far longer than they should. And they take profits too early. Bcos if they cut loss, they have to admit they were wrong, realized their mistakes. But if they simply hold on, it's not realized, there is still HOPE that it will turn around. Vice versa, for profits, once they locked in, they would have proven a point, they got it right. And the right to brag about it later on. So pple always take profit too fast. It is in the wiring of our ape evolved minds. A seasoned investor tries to overcome this malfunction and makes the money.
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