Every investor will, at some point, have an investment that goes wrong.
The challenge is knowing when to sell an investment and move on to other opportunities. This is far easier said than done.
Berkshire Hathaway (BRK.A, Financial)(BRK.B, Financial) CEO Warren Buffett (Trades, Portfolio) has said there are only two reasons why investors should be selling stock: because something else has come along and one needs the money or because the situation has changed.
It is relatively easy to determine if one opportunity is better than another. All we need to do is look at our projected return rates to decide if we should sell one company and replace it with another in our portfolio.
However, trying to figure out if something has materially changed in a company’s outlook is a different question altogether.
Trying to establish if something has changed
Most of the time, a company’s underlying fundamental performance and its equity price do not correlate. This is one of the reasons why fundamental investing works. As investors, we can find opportunities where the market is undervaluing a company’s fundamental performance and take advantage of that.
But while this can increase opportunities, it also makes it harder to distinguish if something is going wrong with the underlying business.
If a company's equity price continues to march higher year after year, but it is suffering from internal corporate rot, we as individual shareholders are unlikely to notice even if we are spending hours assessing and breaking down our ideas. These sort of fundamental changes are often well hidden from investors.
On the other side of the equation, a company's equity price might drop by 20% after it issues a small profit warning. Fundamentally, not much will have changed, but the market’s opinion of the business will.
This disconnect between fundamental value and market sentiment is the primary reason why it is so difficult to analyze if something has changed.
Dealing with losses
Psychologically, it is harder to deal with losses than gains, which is why investors may be more likely to make a mistake if a stock suddenly drops in value. The process of dealing with these kinds of declines is probably more important to come to terms with than anything else.
After all, if something has changed in the company’s underlying fundamentals, but you are still making money, you are unlikely to make an error by selling too early.
We need to make sure we react to any negative surprises with cool heads and a disciplined process.
Personally, I avoid making any significant investment decisions if there is negative news until the weekend after.
That gives me time to think through what is happening, analyze any data and come up with a sensible and well-informed plan, not a knee-jerk reaction.
We also need to remember that the business world does not move as fast as the market.
A company's equity price might drop 20% as the market reevaluates its growth potential, but that business is unlikely to see a 20% change in underlying fundamental value. It can take years for business plans to evolve and develop, which is something investors might only understand if they have been business owners in the past.
Therefore, rather than reacting instantly to news, investors should analyze and digest the situation over an extended period.
We need to assess if the market has overreacted or underreacted, and the only way to do this is through research while having an unbiased opinion. This whole process is not easy, and one is unlikely to get an answer immediately. Investing is a marathon, not a sprint, so it takes time to gather information to build informed decisions.
It also requires a high level of psychological maturity. The most important thing any investor can do to eliminate the risk of making a knee-jerk mistake is to wait. When investing, patience is always a virtue.
