Losing money in the sharemarket? Want to know why?

Sharemarket investing, when viewed from a distance, can look like a path to easy money, but up close and personal it’s a very different story for most investors with widely quoted statistics suggesting that up to 90% of market participants lose money.

Many investors consider investing in terms of the individual shares they own, with each one eagerly acquired and full of promise.    But when shares are considered in terms of an investor’s total portfolio some interesting things emerge.

Years of observation have shown that most of the positive performance in a portfolio comes from a minority of the stocks it holds.  Generally speaking most of the stocks in a diversified portfolio spend a good deal of their time doing not very much at all, making small gains or small losses and mostly drifting along in the general stream of the market.  Sometimes however a small gain grows into a large gain or a small loss grows into a large loss and it’s how we deal with these that really determines our overall outcome.  This is where it gets pretty interesting.

When an individual stock starts to make strong profits exuberance at the success can be mixed with fear at losing those open gains.  So we give in to the urge to ‘book the profits’  and sell while the gain’s still there.  After all, you can’t go broke taking a profit  . . . . . can you?

But that’s only half the story.

When that other thing happens, that losing thing where one of our small losses is starting to get out of hand, we begin to have different conversations with ourselves.  After all, it’s not a loss until I sell it and I’m not here to lose money so I’d be a mug to get rid of it now.  It doesn’t feel nice but I’ll feel better when it goes back up so I’ll wait for that.  Or better still, I’ll buy more down here so it doesn’t need to go up as much before I’m square.

Sadly that day can be a long time coming, if ever.

So, it appears to be a very natural tendency to close out winners too soon and hang on to losers for too long and that’s why many investors get, well, pretty ordinary investing outcomes.  There’s a whole arm of behavioural finance about this phenomenon; it’s called the Disposition Effect and it’s very real and it’s very human.  It’s just not very profitable.

So if selling winners and holding losers is bad, does that mean that holding winners and selling losers is good.  Put simply, YES.  It’s not straightforward though, because it means we need to defy the very real human emotions which are encouraging us to do exactly the opposite.

So, the key to portfolio profits is twofold:

1. Allowing our small gains the opportunity to become some of our few large gains by delaying the gratification of premature profit taking instead of nipping them in the bud, and
2. Denying our small losses the opportunity to become large losses by facing up to the short term pain of locking them in while they’re still small.

It takes discipline.  It’s simple, it just isn’t easy.  Having a system is a big part of the answer, but that’s for another time.