Time to clean up your portfolio

Wishing and hoping doesn’t make a stock go up, so it might be time to cut those underperformers from your portfolio.

With the year still young and reporting season underway, it is as good a time as any to consider cleaning up your stock portfolio.

If there is one certainty in stock market investing, it’s that everyone will make mistakes and pick stocks which just don’t work out as planned. It’s just part of the game that we all have to learn to accept. What is key, however, is to ensure that those you do get wrong don’t wipe out all of the strong returns generated elsewhere in the portfolio.

If there is one piece of advice that has stood the test of time, it’s to cut your underperformers quickly and let your winners run. While most investors have heard this, there are still many who do the complete opposite by quickly selling for small profits and letting their losses run.

At best, the underperforming positions, which are usually accompanied by large unrealised capital losses, are “dead” money. At worst, they fall further and never recover.

For most investors, investment capital is limited. Therefore, it is important to have that money working as hard as possible rather than tied up in stocks that drag on overall portfolio performance and take up a disproportionate and unnecessary amount of investment thinking time.

Instead, this time could be spent focusing on constructive investment ideas that are either already performing well or have the potential to do so. Worrying about when XYZ will recover to the purchase price, if it ever does, so as to sell out with your ego intact is not a wise investment strategy.

Having said all of this, it’s a lot easier said than done. When a stock falls most investors believe they bought the stock at the wrong time or it was simply a case of bad luck. They seldom acknowledge behavioural biases are at play. A couple of the major psychological biases include;

Humans hate admitting they made a mistake – Under the false illusion that it is not a loss until it is realised, investors elect to keep holding the position and therefore avoid admitting to themselves they made an error in judgement.

Hope – Despite the relentless flow of bad news and underperformance, investors will continue to hold their position based on the faint hope that the stock will one day return to its purchase price. Unfortunately, the decision to hold is rarely based on rational analysis or a well thought out strategy. Wishing and hoping doesn’t actually make a stock go up, as much as we all would like it to.

Carelessness – When the market is booming and most stocks are rising, investors tend to pay closer attention to their portfolios. However, during leaner times, and especially during downturns, investors tend to lose interest and neglect their portfolios at a time when they should be paying close attention. Rather than cutting their losses and cleaning out the portfolio, investors do nothing and inherently let losses grow.

“Stocks always recover” – Knowing that the major indices always recover and rise over the long term, investors wrongly believe this to be the same for individual stocks. What they fail to realise is that the major indices frequently reweight by dropping losers and replacing them with winners. The major indices tend to overstate the resiliency of the average stock.

With these psychological issues in mind, here are a couple of ways to help cut those underperformers before they wreak havoc on your portfolio.

Have an investment strategy. Nearly every investor will have reasons as to why they bought a stock, yet seldom do they have an exit strategy. It is important to know the reasons why or at what price you would be prepared to sell the stock.

On a regular basis review your portfolio holdings and ask this simple question: “If I did not own this stock, would I buy it today?” If the answer is no, then it should be sold and replaced with a stock (company) you would like to own.

While no one deliberately buys a stock they believe will go down in value, it’s a part of investing that is impossible to avoid over the long term. Rather than expecting to completely avoid losses, the secret to investing success is limiting the losses before they get out of control.

Ben Potter is Retail Editor at Baillieu Holst Ltd.

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