In 2017, during a Bahrain visit, I was having an informal discussion on market outlook with a small group at a birthday party. One investor sought my opinion about two stocks that he owned: first, a telecom company and second, a cement/construction company.
Both were highly leveraged companies in a debt trap, and were heading for bankruptcy, I suggested that he exit both the stocks even if it is at a big loss and advised switching to a safer high quality stock.
His response was, “I never book losses. I am prepared to wait.”
The telecom stock is down 95 per cent and cement/construction stock is down 65 per cent since that discussion. This is a classic case of the loss-aversion bias in investment behaviour.
Accepting failure is painful and difficult. That’s why trying to avoid pain is a deep-rooted human instinct. But this reluctance to accept the truth is a behavioral bias. It has to be overcome to become a successful investor.
Mistakes are normal
Mistakes are normal in life: “To err is human.” As Theodore Roosevelt said: “The only man who never makes a mistake is the man who never does anything.” By that logic, the best way to avoid mistakes in investing is not to invest at all. That would be the biggest mistake.
Legends of the stock market, who made their fortunes from investing, made many mistakes; but they quickly learnt from them. When Warren Buffett lost around $300 million in US Air debt in the early 1990s, he described his wrong investment decision as ‘temporary insanity’.
Buffett himself described his decision to buy Dexter Shoe by swapping Berkshire Hathaway stock as “deserving a spot in the Guinness Book of Records as one of the worst financial disasters”. Peter Lynch, in his great work One Up on Wall Street, wrote “Selling your winners and holding your losers is like cutting the flowers and watering the weeds.”
India’s ace investor Rakesh Jhunjhunwala, too, has lost money in some of his holdings. But these legends quickly recognised their mistakes, accepted the reality, exited those investments and moved on.
Mistakes are par for the course in investing. What is important is to learn from those mistakes. While successful investors accept the mistakes and move on, many retail investors irrationally cling on to their bad investments and incur huge losses.
Quality always wins
Most portfolios are likely to have some laggards. A typical retail investor portfolio is likely to have many low-grade stocks and even penny stocks. Bull market presents opportunities to get out of the low-grade stocks and to invest the proceeds in quality stocks.
Booking losses can lead to wealth erosion. Investment of the proceeds in good stocks also may yield negative returns for a while, if the market corrects. But the big difference is that quality stocks bounce back like a rubber ball when the market recovers while low-grade stocks languish.
Remove the weeds and water the plants
Removing the weeds and watering the plants is conventional wisdom. Retail investors should utilise the current market euphoria to get out of low-grade stocks even if it means exiting at a big loss and invest the money in quality stocks for the long term. It may take a while to earn good returns from the investments being made now. But rest assured, patience will be rewarded handsomely.
Article first published in Economic Times.