Do You Cut Loss in Your Equity Investment?

As we progress in our investment journeys as an equity investor, it is important to recognize some of the emotional biases which could impede our wealth creation progress. 

For this sharing, I will briefly share on an emotional bias called "Loss Aversion" which was identified by Daniel Kahneman and Amos Tversky in 1979. 

Loss aversion is a bias in which people prefer to avoid realized losses as opposed to achieving gains. As a result, the investor is likely to hold on to his investment especially in some lousy companies and HOPE that the share price will one day, reach the break-even price. 

Scenario 1:

I suffered from loss aversion when I invested into Masterskill in 2010 without proper due diligence, the share price dipped subsequently due to weakening profitability but I refused to sell the company shares. I ended up holding a loser in my portfolio back then without realizing that any investment without proper due diligence is a mistake at the first place. In the end, the shares were sold at a steep loss.

Realizing losses is so painful! If an investor still hold on to the shares of lousy companies, the losses are just unrealized or paper losses, but the investor end up holding an investment in a loss position longer than justified by sound analysis. 

Warren Buffet once said :" time is the friend of a great business enterprise and the enemy for the mediocre business".

If we buy lousy companies' shares and suffer losses due to steep decline in share price coupled with minimal recovery prospect, we will need to CUT MISTAKE although the disposal of shares will result in losses. If we do not cut the mistake, the unrealized loss may increase if the share price continues to head south. This is damaging to our wealth building efforts! 

Do not invest into lousy companies in order to MINIMIZE MISTAKES.

I have a friend who had invested into Malaysia Airlines (MAS) for years despite knowing the fact that MAS had been in a loss making position for years without meaningful improvement in the company's financial position. He continued to hold on to the shares and hope that MAS would perform better one day. Subsequently, MAS was delisted in 2014 at a price which was way below his purchase cost, his unrealized loss became realized loss following the capital repayment exercise of MAS. 

If a company continues to perform poorly, the value of the share is likely to decline further, resulting in higher amount of losses to the investor if he continues to hold on to it.

At the end of the day, one way to minimize loss aversion bias would be via discipline approach to our equity investments based on fundamental analysis. 

Scenario 2:

If we invest into good companies at an attractive price and if the company continues to generate higher profits and operating cashflow, our investment value is likely to increase in the long run. The longer you hold on to the investment, the higher is your potential gains from its potential increase in share price and dividend payout.

If we are in scenario 2, the key issues to think about is not to cut loss or cut mistake, but rather to think of a way to increase our shareholding in the companies in order to earn higher share of profits in many years to come!