Is Holding An Investment At A Loss The Right Thing To Do?
After a big market downturn, when things have settled down and volatility has moderated to something resembling normal, you may find yourself holding numerous investments whose current values are well below the amounts you had originally paid for them. Your inclination might be to hold on to them until their values come back to at least break-even. Is that the right or the wrong strategy to follow?
While the correct answer for any individual is always “it depends,” in general it’s the wrong thing to do. This kind of thinking is based on loss aversion, a behavioral bias that causes us to prefer to avoid losses even if it means missing out on greater gains. It is emotional in nature and counter to a more rational-based decision-making process.
“But my financial planner told me not to sell an investment that has lost value on paper because I’d be realizing the loss. Is she wrong?”
No, she’s correct. Your financial planner was telling you not to sell and exit the market by leaving the money in cash. But what if there’s an alternative investment in the same asset class with a better risk/return profile (i.e. one that is expected to grow faster or protect against losses better than the original investment). Wouldn’t it make more sense to replace the current holding with the new one?
There’s a common misperception that a stock becomes undervalued after a big market drop. That’s because we fixate on its recently higher price and treat that as the price we think it should be. This is the consequence of another behavioral bias known as anchoring. In reality a stock can never be called overvalued or undervalued. It can be high-valued or low-valued relative to its historical price range, but in either case its current price is nothing more than the most recent price on which buyers and sellers were able to agree. Most importantly that price tells us nothing about the stock’s future prospects.
There are tax and other considerations that should be taken into account before selling investments. Tax loss harvesting, for example, is a way of accelerating tax losses by replacing the fallen stock or mutual fund with an equivalent. But how much a stock or fund may have dropped in the recent past should have no bearing on any buy or sell decision.
Good stuff, but as is so common, this point of view uses behavioral finance to discount the real but intangible value of most biases! Loss aversion exists because realizing losses is painful. And ultimately “we are not here for a long time, we are here for a good time” — meaning the purpose of money is to support feeling good, not vice versa. Meaning that it’s great (really) to learn about and pay attention to all kinds of cognitive biases, but not to summarily discount them as irrational.
In particular, it can be rational (more pleasant) to hold onto an otherwise “good” asset with a paper loss, until it recovers, if you can afford to do so, and don’t mind paying the “risk premium” to buy yourself a chance at “feeling like a winner later.” I’ve done this many times in my life, and not regretted it.