Loss aversion is a real thing.
Whether it's a game of Monopoly, a friendly bet, or a heated argument, people hate to lose. Entire businesses and industries are predicated not only on the excitement of winning but also on our innate desire to win back whatever we might just have lost.
This isn't just because humans are a competitive bunch. (Though many of us are.)
It's also because, psychologically, we perceive losses much more powerfully than gains. Psychologists know that, for most people, pain associated with losing something is about twice as powerful as the pleasure related to gaining the same thing. As a famous quote from social science giants Amos Tversky and Daniel Kahneman goes, "Losses loom larger than gains."
Losing $100 feels worse than making $100 feels good. The concept of loss aversion, therefore, is particularly relevant to investing. The fear of losing can overwhelm our other logic-based thoughts when making a decision to sell a stock at a loss.
Anything that hinders objectivity and logic shouldn't be such a large component of our decision-making process -- but, after all, we are human.
That's why I want to focus on minimizing the impact of this powerful loss-aversion factor.
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Most obviously, investors should pull the "sell" trigger when a stock's long-term story changes. This is true for large-cap and mega-cap companies, but it's even more important when it comes to smaller, often unproven (or sometimes unprofitable) companies that operate in new, fast-moving and very competitive industries -- like many of the stocks we invest in over at my premium newsletter, Fast-Track Millionaire.
When a company's story changes, it doesn't necessarily mean that the company is in trouble. But it does mean that you should re-evaluate your research and your investment rationale. More often than not, you'll like your investment less.
To do this efficiently, you should know your investments well. There is really no substitute for this step. If you are an investor with a longer-term horizon -- not a trader or an indexer -- you should do your homework. In fact, this is my role at Fast-Track Millionaire -- I do the research, evaluate new technologies, emerging industries and interesting stocks, and then present my subscribers with a full rationale for a new investment pick. It's my job. Yours is to understand the reasoning and make your final investment decision.
So, what should an investor watch out for? Are there any "tells" that a story has changed?
First, watch out for "noise." Take, for example, some of the selloffs we see after a company reports earnings. These moves can be significant, but often they're just short-term noise. The key is determining whether the company's fundamental story is still essentially the same or if the long-term growth picture is now significantly impacted. Don't become a victim of short-term nearsightedness.
Second, revalue the position keeping in mind the full impact of the newly acquired knowledge. Ask yourself if you would buy this company today, with everything you know, at today's price. If the answer is "yes," you should hold on. If the answer is "maybe," consider taking a loss. Your final decision might depend on the holding's place in your overall portfolio. (And it should go without saying that, if your answer is "no," the best course of action is to sell.)
Third, watch for management changes. For many companies, especially smaller or younger ones like most of the stocks we hold in my newsletter, the future is defined by the drive and the vision of the top people in the company. If they leave, are forced out, retire, or make other sudden moves, it can signal a higher-than-normal level of business uncertainty, which often precedes more volatility in the stock's future.
Fourth, always keep the big picture in mind. Compare the stock's moves with those of its peers, the overall market or its sector. Nothing exists in isolation, and no stock is immune to overall market conditions.
Finally, remain humble. Nobody's guaranteed from making mistakes, and ignoring them could get you into real trouble.
If you didn't sell a big loser when the loss was still small, don't despair. There are a couple things to keep in mind.
One is that an unleveraged long position cannot hurt a portfolio too much unless you continue to double up; that's important to remember if you are confident that a big rally could come at any time.
Second is that you can always book a loss on a position and buy it back at some point in the future. Capital losses in a taxable account can be valuable. And while you shouldn't make an investment decision solely because of taxes, neither should you ignore their impact.
Now, I am not a tax accountant and this is not a tax-related advisory. Moreover, when it comes to taxes, you should always consult a tax professional who really knows and understands you and your situation.
That said, I would be remiss if I didn't point out three things related to capital-losses as things stand now:
1. While there is an annual limit on the amount of capital loss investors can deduct against ordinary income, any losses you don't write off in a specific year can be carried over to future years.
2. Because gains and losses are netted in each category, long-term capital losses are the most valuable to you.
3. There is a 30-day period for buying back a position (or a "substantially similar" position), so be sure to wait 30 days plus one if you want to reinvest in the same position before buying it again, or the loss would be disallowed for tax purposes.
Finally, don't think you have to be able to outsmart the market to be a good investor. But if you are armed with the right strategy -- like the one we employ at Fast-Track Millionaire -- you should succeed despite our natural inclinations against risk and loss.
(This article originally appeared on StreetAuthority.com.)