Cognitive Bias and Recouping Losses in Investing: Cutting Your Loses and Letting Your Winners Run

One investing lesson I was fortunate enough to learn early on was how to swallow your pride, and take a loss from your investments.

Though it can be a tough pill to swallow in the short-term, the benefits (capital appreciation) in the long run generally will greatly outweigh any short-term losses suffered—if you can take emotion out of the equation and not dictate your investing practices, which is often easier said than done.

Acting Rationally, and Sooner Rather Than Later?

When you are down considerably or even in the red on a stock purchase, recovering your cost basis, or “getting back to even” is something that could be a years-long process, or potentially may never occur.

In the meantime, you can miss out on significant gains you could have realized had you bit the bullet and sold for a loss –and then redeployed that capital elsewhere. Additionally, you can take advantage of tax-loss harvesting when you sell for a loss.

The trickiest part is deciding when to cut your losses. Obviously, a smaller loss is always preferable. But, as no one can predict or perfectly time the market, there is an ever-present chance that your losses will only grow rather than shrink.

The law of compounding can make matters even worse. However, the power of compounding usually can be seen as an investor’s best friend.

How Compounding Works

A quick explanation for any newcomer to personal finance, is that, when the value of the individual investments you own goes up (or down), the balance in your investment account will go up (or down). As long as you leave the difference invested, your returns will have the opportunity to compound over time.

More important than timing the market is time in the market. The longer you stay invested, the more time your potential earnings get to compound, and the greater your potential growth. Both in terms of compound interest (if the stock is dividend-paying) and compounding returns in general.

Mind you, this phenomenon also works the same way with losses. The longer you stay invested, the larger those losses – relative to your principle – become.

The biggest takeaway is that a stock is worth what it is worth today—not what you paid for it; not what it may be worth in the future. The best thing you can do is to view any individual holding in terms of current equity (value), rather than your principle, or total gains or losses.


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