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.


  1. Happy New Year, "8%"! Your blog always puts a smile on my face by your no-nonsense sharing. I confess I am one of those people with "ape evolved minds", taking profits way too soon and dithering over whether to cut loss and when to do so. Rather pathetic, sigh.

    Have a question for you please. Everyone talks about the magic of compounding interest. But where do you get such a good "lobang" that offers an almost guaranteed consistent interest over the years? I checked with my bank manager and all he could offer was fixed deposit! And at a pithy interest rate of 2%, it cannot even beat the inflation rate. I know you are not a fan of unit trusts but is that the way to go? Equities are a lot riskier, right? Hope to pick your brain.

  2. Hi there,

    Sorry to tell you that there is no guaranteed consistent interest. 8%pa comes with risk.

    There is a risk that you will still earn a negative return if you put your money in stocks.

    But tat risk diminishes if you hold the stocks long enough. Say about 15 yrs, haha. That's the truth.

    Buying individual stocks can be quite risky bcos if you bought a crappy co. even if you hold it for 50 yrs, it may still give you negative return. That's why I think index funds may be a better solution.

    As for compound interest, it's really not much of a magic. Again you need time and patience... Roughly, it takes 15 yrs to make 2-3x your original principal amt by using compound interest.

    This is quite significant bcos if you just save $500 every mth, it becomes $180k to $270k in 15 yrs...

    I have got a few posts written abt these subjects, can try to find and read them. Cheers!

  3. Thank you for your advice. The problem I face is WHERE to park that $500 every month to maximise the returns. Bank interest rates are just way too low.

    Will read up on index funds.

  4. Well Singapore govt T-bills is a good place, currently it gives 2% or so. But minimum size is $1000.

    ETFs are good vehicles to invest in but you need to invest in bigger sums so that you don't pay too much in commissions. A good ballpark would be $5000, so you pay $20 commission, and it amts to 0.4% commission.

    Compare this with buying unit trusts where they charge you 3% commission upfront plus 1% mgmt fee every yr!