This is a fascinating subject for me, not so much for its mathematical structure (which is simple and well understood) but more for its behavioral consequences. Let me clarify with an example. Suppose I buy Coca-Cola Company stock on May 16th 2013 and are reviewing my performance on October 9th 2013. Using closing prices, and excluding dividends and commissions for simplicity, the stock went from $43.09 to $37.08, which represents a change of -13.9% in 146 days. Here’s what I can do with this information:
- Sell the stock.
- Stay put.
- Buy more of the stock.
Notice that the actual loss is not in question here: I am not making the foolish distinction between “paper” and “realized” losses; I have lost money. But what I am doing is deciding what this loss in a little less than half a year on a common stock position means. (We can extend the argument to an entire portfolio.)
It’s up to you to decide what losing money really means in investing. It is an important prerogative, because it will likely determine how successful you will be in managing your portfolio. I think of it as “the termination of a losing position when recovery within an appropriate time period is not an option or when certain events make that recovery extremely unlikely”. The elements then are the time period over which the calculation is applied and the nature of your investment. Except in very specific situations – fraud, theft or truly sudden catastrophic business demise – your choice of time frame and its coherence with your investment objectives should suggest the right behavior. To continue with our example, choosing alternative 1 above is foolish, unless we found out Coke causes cancer. Choices 2 and 3 are both correct and similar actions, with the difference that 3 imply increasing one’s exposure to the investment.
A corollary of this viewpoint is that establishing certain parameters on your investment performance can be very unhelpful. Example: “never lose money”. Despite its seductive simplicity, this restriction is practically useless because, again, you are missing important information: the time period over which you don’t want to lose money and the type of investments. Is the period one day, or one month, or one year, or more? And for investments in cash, or bonds, or stocks, or…? “Never lose money” is virtually impossible with anything but money-market vehicles for horizons shorter than one year; if you think in terms of rolling 20-year periods then even equities never lose money. As I said, it’s up to you.
Conventional practice calls for analyzing and making decisions based on the performance of your investments over very short time periods. Most of you are provided with – and demand for – monthly, quarterly, semi-annual and annual performance reports. This practice carries the risk of unduly influencing you to take decisions that may damage, instead of improve, your financial wealth. Caveat emptor.
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