There are many skills investors require to be able to survive in the market over the long run. Self-awareness and humility, as well as emotional intelligence, are some of the most important.
Indeed, one of the biggest mistakes an investor can make is failing to acknowledge that they have made a mistake, and rather than selling up and moving on, they throw more good money after the bad.
Putting good money after bad
One of the most misunderstood ideas in the investment world is that buying falling stocks is a good idea. It doesn't matter if you already own the position or not; acquiring shares in a company solely because they have fallen in price is never a good idea.
Instead, investors should concentrate on intrinsic value. The intrinsic value of every stock is what matters, not its price.
In my experience, it is generally the case that nine times out of ten, a stock price has declined because the intrinsic value has fallen as well. The market is reasonably efficient when it comes to valuing businesses. There are occasional spots when Mr. Market does act irrationally, but by and large, today's investment environment is a lot more efficient than it was when Warren Buffett (Trades, Portfolio) was making his first millions back in the 1960s.
Therefore, if a stock looks cheap today, that's probably because it should be. If intrinsic value is falling for whatever reason, it is tough to turn the struggling business around. That's why it does not pay to throw good money after bad.
There are only a handful of examples of large and small businesses that have managed to pull themselves out of a steep decline and recover to a stage where they can produce attractive returns for investors.
Most of the time, these businesses get stuck in a sort of doom loop where managers have no choice but to cut costs, which impacts customer service, research and development and distribution. This hits sales, which then drives management to cut costs further and so on, until there's nothing left. Companies that have been able to use economies of scale to grow suddenly find that diseconomies of scale are just as important, and can be much more damaging.
These factors are always important to keep in mind, but are even more true during a period of significant economic and technological change like today.
The businesses that cannot keep up with the change will be sidelined. Meanwhile, those businesses that are trying to get off the ground using a new technology or moving into a new industry can be equally as dangerous for investors.
Throwing more good money after bad in a struggling startup is just as dangerous as doing the same with an old-world industrial company that is struggling to adapt to the 21st century. A dollar is still a dollar no matter where it comes from or where it is invested.
Increasing intrinsic value
There is nothing wrong with putting new money into an old investment, but before you do so, you should always consider whether or not the enterprise has increased its intrinsic value, or if it is going backward. Because most companies struggle to stop a decline once it has started, if intrinsic value is falling, it might be best to stay on the sidelines and avoid the business until an improvement (if any) happens.
The one great thing about being an investor is that we never have to take an opportunity. Nothing is stopping us from sitting on the sidelines and waiting for the right time to buy for decades if we have to. That's why it does not make sense to throw good money after bad just because you already hold a position.
Disclosure: The author owns no share mentioned.
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