Most investors know that one of the golden rules of being successful in the market is cutting your losers short and letting your winners run, but it is much easier said than done.
Most people intend to do this but when it comes to the crunch they can't force themselves to sell for a small loss and decide to hang on in the hope the stock will turn around and head higher.
It’s one of the biggest mistakes in trading/investing and we have all done it. I’m not here to preach although I am going to share some insight on a common problem that occurs after this, which is probably an issue many people are being faced with at the moment.
Lets assume you purchased some Leighton Holdings (LEI) at the beginning of 2012 for around the $23 mark.
Nearly all market participants purchase stock because they think it’s likely to appreciate in price. However, sometimes this doesn’t happen, for whatever reason and you find yourself holding a stock that has depreciated in value, sometimes quite significantly.
In the case of Leighton Holdings, by mid-2012 the stock was trading down around the $15 mark. By this stage, the common thought process includes ‘its too late to sell’, ‘I’m a long-term holder’ and ‘if only it can get back to break even, I’ll sell’.
As we’ve seen in Leighton Holdings, the stock price has done what we wished for and started to go back up towards our purchase price. Now the thought process goes some thing like this: ‘Thank god, that was close, now we can get out of the trade for break even and move onto something else’.
This is one of the biggest mistakes people make, and one of my family members just did this with Leighton. The reason you bought the stock was because you thought it would appreciate.
It went down, you didn’t sell and now it has done what you hoped for and reversed and is now trending higher.
I know it’s hard but you don’t want to sell a stock that is going up, even if it has finally come back to your purchase price. If you do, you run the big risk of watching the stock continue its trend higher, which can be incredibly frustrating.
Remember, trends in the market tend to continue a lot longer than anyone thinks they can, both on the downside and upside.
I think this is even more important given the stage of the cycle we are in at the moment. There are a lot of investors who mistimed their investment in the market and are now facing this scenario.
After a such a big economic downturn globally, what we are witnessing now is the beginning of a new cycle. The reporting season just gone showed us that much of the investment community had priced the industrial and cyclical sectors of the economy for structural change, when in fact they have just been cyclically pressured. A classic example of this has been the huge rush of ‘upgrade to neutral’ recommendations seen across the industrial and cyclical sectors.
In my view, what we are seeing here is just the realisation that these sectors are not headed for Armageddon. After five years of downgrades, it looks like we are heading into an upgrade cycle for these sectors.
Management teams have done a good job of stripping out costs, with balance sheets now in good shape just as the Australian dollar is moving lower against the US dollar and the 175 basis points of Reserve Bank easing is beginning to make its way through to the real economy.
As these above factors gain traction and the sluggish East Coast economy begins to recover, we’ll see confidence picking up more. There are already signs of this, with auction clearance rates jumping considerably of late.
Hence, one of the big risks at this stage of the market cycle is selling equities too early.