Investor's Sin No. 1: Holding on to Losers

A common problem among inexperienced and experienced traders alike is a tendency to hold on to positions for too long.

When traders won't let go, they are not only risking the chance of losing their capital, they are also tying up capital that could otherwise be invested in opportunities elsewhere.

"I initiate well but don't liquidate well," said one fixed income trader. "I don't liquidate when it is about to reverse. I understand intellectually what to do. I have trading signals that should take away judgment and emotions. I should get out when the trade first reverses, but I don't."

"The catalyst would come and go, and I would still be there," said another trader. "I need to move when the catalyst moves. I am staying with names too long. I am not as quick to pull the trigger if it moves against me."

For inexperienced traders, the most natural human reaction when a trade is going against them is to hold on to the position. Usually by the time they start to sell out, it is already too late. And in hindsight, they usually feel angry that they did not sell out earlier, so that they could avoid a huge loss.

Traders who hold on to losers need to focus more on their daily targets rather than trying to save money or get it back by holding on indefinitely until something returns to where it ought to be. Such wishful thinking keeps them from being fully in the game.

There are actually a variety of reasons why traders hold on to losers. In the following, I review just a few of them in an effort to expand on their psychological origins.

Problem No. 1: Being Too Loyal

Sometimes a trader simply loves the company too much. He is too attached or too loyal. "My strength is my weakness," said Samuel. "I love the company. I feel guilty selling stocks I know so well."

To trade in the zone, traders cannot allow a sense of loyalty to hold them back. They have to read the supply and demand dimensions of the market and catch the wave of buying and selling.

"Ultimately, all we do is trade supply and demand shifts, the story, the change of story, and so forth," said one trader. "Our ability to profit comes from being on the right side of those shifts, not from loving anything."

"I get too attached to it and trade it two or three times until I finally get it right," said Nina, a bright young assistant who had started to trade her own account in the last six months. "Sometimes enough is enough and I have to take the stock off the screen literally so I am not distracted by the stock blinking on moves. Otherwise, it keeps catching my eye, and I keep thinking I've got to get back in."

Remember, your feelings about the company don't mean anything fundamentally. If the buyers are buying it, even if the earnings are lousy, it is likely to be in an upward momentum. However, if the earnings are good, they may be selling it off, and the price may be dropping. It doesn't matter. The key to success is to see what the market is telling you about the stock and then go after it. Give more credence to what is happening than to your attachment to the company.

Problem No. 2: Saving Face

Other traders hold on to losers out of a sense of egotism. They want to prove their original decision was right, and curiously, the more they lose, the more convinced they become about the validity of their premises.

For example, Kyle was losing quite a bit in one stock because of what he believed was a negative rumor about the company. He was convinced that, with the current business model, the company would succeed in the long run. Unfortunately, he was wrong.

"I love to be right," he said. "That's why I hold on too long to trades in which I should get flat."

Some traders hold on to losers in an effort to get it just right - making themselves appear more competent.

Brent constantly waits for the precise price before acting. He didn't want to short a stock at $43 but waited for $45, the perfect level. The stock dropped to 30, and he missed his trade. He concentrates so much on reducing his losses or his potential for losses that he misses a big chance for profitability.

As he noted, "My analysis and control are killing me. I am squandering opportunities."

There should always be a reason for your trading moves. A decision should never be made in an effort to protect your ego.

Problem No. 3: Keeping Stub Ends

Another form of holding occurs when traders retain a portion of a stock after they have sold off the majority of a larger position.

They hold on to the so-called stub end of the trade for no other reason than to have at least a little piece of the stock in the event that it turns into a bigger opportunity. This habit ties up a large amount of capital that can be used more profitably elsewhere and may also be the source of additional losses if the stub end continues to move downward.

"Stub ends kill you," said Earl. "They reduce the overall profitability of the trade. It is a matter of latent greed or laziness."

Problem No. 4: Averaging Down

Some traders not only hold on to a losing trade but buy more of a stock as it is dropping, rationalizing that by paying less for the stock they are 
lowering the average price of the stock.

Of course, this is fine if the stock moves up, but if it doesn't and they stay in the losing position, they will lose more money and not get the benefit of averaging down.

A trader should decide on a stopping point for risk management purposes, and when that point is reached she should get out of losing positions -without rationalizing her mistakes by averaging down.

Averaging down is a psychologically risky move at best. Even when a trader does it for the right reasons, he must beware of the inclination to experience the decline in price as a "loss" even though it was consciously chosen. Doing so may compel him to sell too soon when the stock reverses direction and moves back to its original price. Relieved that he has eliminated the "loss," he may not hold on as the stock advances in price. Therefore he may not get the full benefit of the upswing move.

If a trader has "done his homework" and is justified by the knowledge that the fundamentals are sound, that there is a good story that has not changed, that the dropping price does not indicate a significant change in the stock's value, or that there is a good reason for the stock to drop temporarily, then averaging down could make sense.

"I get emotional. Even though I intentionally buy more as certain stocks drop in price because I know the fundamentals are good, I still experience the drawdown as a loss and then try to get out of. a stock as it moves up," said Randy.

"I rationalize it as it goes down, but I still feel pressure to get out of it as it moves up. It's a mistake. Averaging down to save yourself is different than averaging down because you are investing in it. Take the loss when it is not a good situation but when you are building up a position. When it goes up, remember it is going where you want it to go. Ride the profitability. If a trader is averaging down for the right reason, the key to making it a successful trade still lies within his psychological ability to ride out a big drawdown and then let the profit run to the max."

What You Can Do About It

Regardless of the reason, to overcome a tendency to hold losers, a trader must go back to following a goal-directed strategy. Traders need to focus more on their daily targets rather than trying to save money or get it back by holding on indefinitely until something returns to where it ought to be.

The value of a goal is that it gives you a reason for getting out of the trade. If you are not motivated by the number, you stay in a trade hoping for "the big one." But if it goes in another direction, eventually you lose your money and then you may spend the next trade trying to recoup.

One way to stay on target and overcome the tendency to hold losers is through organization.

Earl, an experienced portfolio manager did just this by developing a spreadsheet of his positions and key variables relating to his positions so that he could determine in advance when to add to his positions and when to sell them off. His spreadsheet included variables such as:

• Cost versus current price.
• Target return in dollars.
• Risk in dollars.
• How many days to be in the trade.
• Percent of capital to use for specific trades.
• Upside and downside.
• Current profit and loss on the position.

"Refer to the sheet during the day," said Earl. "If it is up two and it is not on the sheet, we should have it on the sheet. All the decisions should be understood and kept on the sheet."

The key point is that prices don't lie. Don't guess. Watch the movement of the stock and trade according to a strategy, not emotion.

Ari Kiev
Author of Trading In The Zone

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