The most common and costly mistake in investing is something very obvious and simple, but is quite hard for most people to do on a consistent basis. That mistake is not cutting losses quickly. Systematically cutting losing positions at an early stage will do more to improve investing results than any other tactic or strategy. Holding onto losing positions too long is what hurts investment returns more than anything else.
This isn't a big secret. Most investors are well aware of this problem. Quickly cutting losses is at the center of all trading and investing advice. It isn't complicated or complex, but most people just don't do it very effectively.
Why don't we do such an easy and obvious thing? The psychology and emotions that prevent people from doing what is in their best interest are very complex. There is a natural bias against selling a stock for a loss, because it feels like we are admitting that we made a mistake. One of the first things that most people learn about investing is that very successful investors like Warren Buffett hold onto stocks for the very long term. They don't sell when they have small losses. They buy more. They have confidence that they made a good investment, and they aren't going to allow irrational market volatility to shake them out.
But even Warren Buffet will eventually admit he made a mistake and take his losses. He did very poorly with a number of airlines, and just this past week, we sold some shares of HP, Inc. (HPQ) for a loss. Investors like Buffett have a problem that most individual investors don't have -- they are too big to be flexible. They can't move in and out of stock quickly. They can't buy a position again in the blink of an eye like a small investor can.
The buy-and-hold mindset and the inclination to not admit a mistake is one reason that there is a bias against taking losses, but the more basic problem is the failure to have a clear plan in case a stock doesn't perform. Too often, when someone buys a stock, they don't even consider what can go wrong. They want to focus on what can go right and what they are going to do with all those profits when they come rolling in.
When there is no clear plan to deal with a stock that is acting poorly, there is an inclination to find justifications for why we should just hold on. The most common excuse is that the market is wrong about the stock and is mispricing it. We see it as an opportunity and add more, because we know it is a great stock.
We can always find a way to justify holding onto a losing stock, and we are wired to do so. It is much easier to do this when there is no plan, so we don't bother having a plan in the first place.
The solution is to change the way you think about taking a loss. Don't think of it as the end of the trade and the death of the stock. Think about it as a simple form of insurance. You can always rebuy the stock and try again. You are simply stepping aside so that you can reassess.
To paraphrase William J. O'Neill, the founder of Investors Business Daily:
"How you think about losses is critical. Historically, this is where most investors go wrong and get confused. Did you buy fire insurance for your house last year? Did your house burn down? If it didn't, were you upset you wasted money on insurance? Will you refuse to buy insurance in the future? You buy insurance to protect yourself against the remote possibility you could suffer a major loss that would be difficult to recover from. That's all you do when you cut your losses short."
Selling a lost stock is just a form of insurance. If you re-buy it later at a higher price, then you have simply paid an insurance premium. You may even have an opportunity to re-enter at a lower price, but the important thing is that you have eliminated the risk that is created when a stock is moving the wrong way.
There are two solutions to the problem of not cutting losses. The first is to have a plan and to have the discipline to stick with it. The second solution is to change your mindset and think of selling as just a form of insurance. Insurance should just be part of the trading or investing plan. It has nothing to do with the quality of your decision-making. It is a tactic that gives you greater flexibility.
The single best way to improve your investing results is to be a better seller, and that starts with having a plan and taking losses quickly and decisively.