Stock market adages put to the test – (for the next round of mulled wine)

«Cut your losses and let your winners run.»

 

The human brain isn’t wired to operate and maneuver tactically on financial markets. Psychology plays pranks on investors from time to time, and (financial) mathematics can also be tricky. But you can sidestep psychological and mathematical pitfalls by following a simple stock market maxim.

 

Investors who play the stock market on their own definitely don’t have it easy. The amount of available data, analyses and news has increased massively in recent years, and as a result, investors these days are confronted with a veritable flood of information. Alongside this relatively recent phenomenon, there is also another obstacle – the human psyche – that regularly stands in the way of investment success. “Buy low and sell high” is something that everyone would like to do, but this countercyclical mode of investment behavior usually goes against our instincts. We prefer to wait for a stock price to rise as a confirmation before buying. And again when we sell stocks, our timing (especially that of less experienced investors) is likewise oftentimes bad, and in the worst case we sell in a state of panic close to a stock’s low point. Our good intention thus unfortunately all too frequently ends up devolving into “buy high and sell low.”

The pitfalls of investor psychology therefore shouldn’t be underestimated. In this context, the stock market adage to “cut your losses and let your winners run” is one of the sagest maxims. But adhering to it is much easier said than done because cutting losses and letting winners run once again goes against what our instincts tell us to do. In reality, we are actually subject to the disposition effect – we take profits too soon and let losers run. Why? Because pocketing gains doesn’t just reinforce our self-confidence and give us bragging rights, but is also an act of finality and ends the risk of an investment. Holding onto losing positions, on the other hand, preserves the (oft-futile) hope of a price rebound and averts having to admit a potential (investment) error. That’s why (retail) investors much more prefer to hoard a “cemetery of corpses” in their securities portfolios.

The reason why it’s so important to overcome typical human tendencies and rigorously cut losses is explained in another, less-known stock market maxim that was coined by André Kostolany († 1999): “You can win, you can lose, but it is impossible to win back.” This somewhat awkward adage harbors an essential mathematical truth (that unfortunately is not entirely intuitive): the greater the preceding loss, the (disproportionately) higher the subsequent gain must be get back to the original acquisition price. If a stock price, for example, drops 50% from USD 100 to USD 50, a subsequent 50% rally lifts it only to USD 75. The percentage gain needs to double (to +100%) to get back to USD 100. If a stock price plunges 80%, it afterwards needs to climb 400%(!) to get back to breakeven.

Therefore, whoever consistently limits his or her losses lays a key foundation stone for long-term investment success. (That’s why we actively manage risk and investment positions in our asset management mandates.) Although every investment needs sufficient “room to breathe,” it nonetheless makes sense to define a maximum allowable drawdown for each portfolio position and to systematically secure it with a stop-loss order. This should largely avert catastrophic losses that are near impossible to recoup, even with extreme patience, due to accursed financial mathematics. For investors who manage their portfolios themselves, Yuletide is a good time not only t devise a loss-limiting strategy for 2022, but to also separate the wheat from the chaff. If this “inventory” turns up proverbial horses that already bolted the stable before you could close the gate (i.e. if it turns up positions in stocks with book losses greater than 25%–30%), you shouldn’t automatically pull the ripcord. In such cases, investors should instead ask themselves whether they would reinvest in each of those companies at today’s share prices based on the information currently available.

 

Accursed mathematics
Investors with pocket calculators are clearly at an advantage

Scenario analysis: Losses and the subsequent gains needed to get back to breakeven

Source: Kaiser Partner Privatbank

 

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