What to do With Losers in Your Portfolio
There’s no worse feeling than watching a stock in your portfolio drop in value day after day with no end in sight. If it falls less than 10%, you say the markets are just going through a small correction. After it drops 20%, you tell yourself that it must have finally bottomed, but when it keeps falling, you may start to panic.
There’s one inevitable truth all investors must face: eventually, you will own a losing asset. The key to successful investing isn’t knowing when to buy a stock, it’s knowing when to sell it. That holds true whether the stock goes up or down, but understanding when you need to cut a losing investment loose is what separates good investors from great investors.
It comes down to simple math. If a stock drops 10%, you need to gain 11.11% in order to break even. After a 20% loss, the break-even point jumps to 25%, and if it has lost 50%, it’ll need to double in value just to prevent a loss.
In order to make a rational decision on whether you should keep a stock or sell it, you’ll need to answer three questions first.
Why Did You Buy the Stock?
If the reasoning behind why you bought the stock has changed, then you might consider getting rid of it – especially if its declining in value. If you bought a stock because it had a high dividend yield and management cuts the dividend, then the stocks circumstances have changed. If the stock is dropping in value along with most other stocks, it’s likely a macroeconomic reason and doesn’t affect the fundamentals of the stock you own.
Does Your Portfolio Need to be Re-Balanced?
Every so often your portfolio needs to be readjusted to keep in line with your risk tolerance. Some stocks gain more than others and subsequently take up more weight in your portfolio. As your risk tolerance changes, you may need to adjust how much money you have allocated to riskier stock picks. Investing in high risk speculative companies may be exciting, but too much of them in a portfolio can spell disaster.
Can You Use the Loss to Offset Gains for Tax Purposes?
If you have a losing stock in your portfolio, you might consider using tax-loss harvesting to reduce the amount of taxes you’ll need to pay at the end of the year. Selling a stock at a loss allows you to offset your income up to $3,000 in a single tax year. It might not be a profit, but at least it helps you reduce your tax burden.
One warning for those of you struggling to cut your losses: don’t bail out your money by throwing more money at a losing stock. Averaging down by purchasing more shares of a stock after its declined in value is dangerous. The idea is to lower your average cost per share, which on the surface seems like a good strategy. The problem is that averaging down can be a panicked reaction to seeing a stock drop in value. If its for fundamental reasons, then you’ll end up in a cycle of averaging down until you have a much larger percentage of your portfolio in that stock than you wanted just to bail out your original investment.