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When Do You Sell a Losing Investment?

Posted by admin on July 4, 2007 in Investment Advice, Investment Strategy

Most investors I know have had at one time or another a real loser of an investment- a complete dud which is good for nothing more than a tax loss. Typically, the investor has bought the investment at the height of the market and watched its price fall due to internal factors in the company (i.e. it turned out management was inflating its financial statements) or larger economic factors (i.e. no one adopted the new technology or the consumers got tired of buying white shirts and khakis only). As one of the real curiosities of the psychology of investing, most investors I know have kept this losing investment. When asked why they continue to have this investment in their portfolio, the explanation is usually the same- I will get so little money if I sell it, I might as well keep it. As a result, everyone seems to have a little Nortel, JDS Uniphase or Bombardier in their portfolio (money-losing real estate investments tend to get liquidated quite quickly because a mortgage has to be paid regardless of rental income so the dud properties do not hang around too long- it is sold by you or for you).

Having sold my Science and Technology Fund at a loss several years ago, I have often debated when the best time to sell a money losing investment is. Do you hope there will be a turn-around like Apple did several years ago or are you hopelessly dreaming that Steve Jobs can clone himself many times over and save your investment? In my case, I just got tired of looking at the money I had lost and given that the fund had traded sideways for 18 months, it was best just to sell and move on.

Having said that, I do look at a few factors before I sell a loser:

1. Is the investment doing poorly because of an industry issue or a company issue? If the entire industry is in a downturn, your dud investment is in no worse of a position than any of its competitors. For example, the forestry industry is in a down cycle right now; your dud forestry stock is performing poorly due to factors beyond its control. However, if the entire industry is doing well and your dud investment is not, you have a real problem. If management cannot turn a profit as well as its competitors in good times, what do you think will happen in the bad times? However, if the economy has moved on from the entire industry, you have a very serious problem and it may be time to sell. This often happens in fashion and it occurred in high-tech earlier this decade when the money was spent more cautiously than in the glory deals of the dot com bubble.
2. The dud investment is running out of cash. Pretty simple isn’t it- as the cash dwindles, the ability of the dud investment to stay afloat decreases. Check the balance sheet and the statement of cash flows to determine the dud investments’s cash position year over year. If it has been declining for many years over, the dud investment has some serious issues which are not going away any time soon.
3. What are my opportunity costs? Have I hung on for so long, have I missed many other boats? If so, and opportunity is arising again, is it better to cash out at a loss and take the tax loss and what little money I get from the sale to pursue other opportunities?

Buffet’s first rule of investing is never lose money. While I would like to say I have always followed this rule, most people have held a dud investment from time to time. For those who believe that holding blue chip stock is a guaranteed strategy to avoid a dud investment remember that Bombardier was once a solid dividend-paying stock and Enron had one of the largest market-caps on NYSE. There are simply no guarantees in investing.

I would like to know what “rules” you may have for cutting your losses short. All comments appreciated.