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What to do with the Losers? By Stephen J. Butler

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The History Channel has been airing a fine documentary entitled "The Crash," which describes the 1929 bloodbath on Wall Street. In one segment, an eighty-year-old stockbroker tells of a man who entered the brokerage office in 1968 to sell shares of RCA. "Why are you selling and when did you buy them?" the stockbroker asked. "I am selling because they have finally reached the price I paid for them, and I bought them in early 1929," the man responded.

During the Roaring '20s, Radio Corporation of America shares went from $2 to over $500. Then they plunged and took 40 years to recover. On its way up, RCA was the Microsoft of its day as it commercialized the invention of radio. On its way down, it resembled many of today's Internet stocks, whose investors bought into the hype of unlimited potential.

There are a number of lessons in this anecdote for a retirement investor. For starters, there is the need to diversify. No broad cross-section of stocks dropped as precipitously as RCA nor took as long to recover.

Another lesson is the psychological makeup of this RCA investor. He couldn't bear to take a loss and waited forty years to get his purchase price back. I can imagine the discussion with his wife (if she was still alive) when he walked into the house and announced that they hadn't lost money after all on his brilliant purchase of RCA.

What do we do with a stock or mutual fund that is in the tank? The conflicting forces are to hold on or to sell. Setting aside commissions and tax considerations, there is a theory that says that any day we continue to hold a stock is a day we have effectively elected to buy it.

Studies show that people are always more likely to sell a stock when they have a gain than when they have experienced a loss. We probably act the same way when we are selecting, or moving money around in, our mutual funds.

The fundamental problem is ego. If we have a loser, we don't have to admit to the loss until it actually happens. If a stock is down in value, it is only a loss on paper (an "unrealized loss" in accounting terms). When we actually sell the stock or the fund, we have a "realized loss," which we can do something with -- like apply as a tax deduction.

If you hate facing up to your losses, you have a lot of company. A wide universe of investors has proven to be reluctant to sell losses compared to gains. A Journal of Finance study shows that in any given year, investors will sell 14.8% of their gains but only 9.8% of their losses.

In theory, anyone selling stocks that trigger gains should sell a corresponding amount of stocks that trigger losses. However, something called the "disposition effect" operates subconsciously and disrupts rational thinking. This effect is so powerful that there are actually several different terms that researchers use to describe our deep-rooted tendency to hold losers too long and sell winners too soon.

Exploring the inner workings of the mind can be helpful as we review the investments in our retirement plans. If the year 2000 is any indication of what lies ahead, we will have more difficult decisions to make. Choosing mutual funds won't be as simple as choosing the one that gained 18% per year versus one that only averaged 14%. On the contrary, we may be deciding between those that "only" lost 10% over those that lost 32%.

If you are agonizing over what to do with a stock that has plummeted, remember that if it goes down and demonstrates reasons for staying down, you are better off selling and investing elsewhere. This brings us back again to the need for diversification (i.e. a mutual fund), which can shelter you against the wide value swings that can be characteristic of individual stocks. For example, an investor who has 75% of her 401(k) in her employer's stock should diversify those assets to other investments.

Next, try to establish "mechanical" investment techniques that remove the need to be thinking about when to buy and when to sell. Re-balancing a portfolio at regular intervals and dollar-cost averaging of contributions can remove the uncertainty and the timing conundrum that afflict both average investors as well as the pros.

Troublesome behavioral phenomena feed on the indecisive mind like mold in a petri dish. Once we are caught in this swift current of emotions, only extraordinary good luck can bail us out.

Any of us who has been in the market for the past 5 to 15 years can feel like a genius. Events of the past twelve months suggest that investors will need more discipline and self-control. That means making the tough decisions now on your losers. Otherwise, you can wait four decades or so - like the ill-advised RCA investor - and be mentioned on a History Channel documentary in the year 2040.

BUYandHOLD does not offer or provide any investment advice or opinion regarding the nature, potential, value, suitability or profitability of any particular security, portfolio of securities, transaction or investment strategy. Any investment decisions you make will be based solely on your evaluation of your financial circumstances, investment objectives, risk tolerance, and liquidity needs. The securities mentioned above are being used for illustrative purposes only and should not be regarded as an offer to sell or as a solicitation of an offer to buy and past performance is no guarantee of future results.