by Josef A

Created on: May 25, 2009   Last Updated: May 27, 2009

There is nothing worse than seeing your stock skyrocketing after having sold it with a loss. This is one of the psychological mechanism at work when we try to hold on to our positions that have brought us nothing but losses. Another typical effect is that we turn into investors with a long term outlook. Once our shares start dropping we claim that we wanted to invest our money for years anyway and can sit it out. All excuses why we will not sell our shares with a loss and ultimately acknowledges one thing: We made a wrong decision and we lost money. We think as long as we have not realized our losses they are only on paper and not real. I think you are getting the point; many of us hold on to the stocks that are deeply in the red for all the reasons above. It is easy to explain why this is not a good strategy.

You will meet the famous anti-cyclical investors who always do the exact opposite of the market and become tremendously rich with that strategy. Next to the fact, that to have such perfect timing is quite difficult and even those self proclaimed wizards never hit the exact bottom of the market, such advice refers to the overall market cycles. When it comes to individual companies the situation is somewhat different. Successful companies often remain successful, mediocre ones stay mediocre, and under-performers remain under-performers.

This should by no mean indicate that bad performers cannot make a comeback and become successfully. However, it is a much more likely that the number one or two of an industry will remain on the top in the near future. Take sports as an example, would you rather invest your money in Federer and Nadal or some of the players ranked beyond the top 100. Certainly one of the unknown players will make it to the top one day, but it is much more difficult to figure the right one out than going for the top players. It is a safer strategy to keep your well-performing stock and sell the under-performers.

In fact, many do the opposite. They sell the stocks that have gained some money and keep the bad ones hoping to recover from their losses. This strategy leads to a portfolio with under-performing stocks and the chances are high that they remain under-performers. So exchange your bad players as a sports coach would do. Not after one or two bad games, but after a continuously bad performance the chances are high that you picked up a badly functioning company. Accept it and go for the stocks that have risen, even if it hurts. In the long run this is the much better strategy.

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