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Are you an investor in stock? Did the loss or profit that was made on a stock influence your decision to sell or hold that stock? If yes, then you will definitely need to go through the rest of this page.
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Those who succeed in the stock market say that shares are a great investment. On the other hand those who fail quite often mention that share market is more of gambling. Shares are definitely one of the best investment avenues. However investing in stock requires understanding of business fundementals and common sense. I have a strong conviction that understanding of business is not too important if you are sure that your money is going to be with a strong management team. However, there is no substitute for common sense and unless someone has that, it is indeed difficult to make money in the market.
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One of the most commonest mistake that people do is to take their selling decision based on their purcahse price. Let us take two categories of investors who decide their selling decision based on the purchase price. The first case are investors who want to hold on to their stock because the stock price has gone below the purchase price. The second case are those who want to sell their stock because they have suffered considerable loss on the stock already.
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Among those two, who do you think are the most rationale group? If you answered that it is the first group then you are wrong. But if you think that second group is more rationale then again you are wrong. Neither of them are rationale investors. The loss that one has suffered on a stock is a past event and your selling or holding decision cannot undo such losses. In short, those are sunk costs and your subsequent actions will have no impact on them.
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Once you purchase a stock, the purchase price should cease to be a factor driving your sell or hold decision. What should drive your decision is the return that you could expect on stock at its prevailing market price.
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Let me illustrate it with this example. Suppose, you bought a stock for Rs.300 three years earlier and the stock now trades only at around Rs.150. At the same point in time you see another stock that has been doing so well and has got a potential to earn 20% return based on its prevailing price. Investors might generally get tempted to switch stock at this point in time. However, just imagine that if on the other hand the stock that is trading at Rs.150 is undervalued and can has the potential to yield a 30% return. If you decide to sell the stock at Rs.150 and switch to the other stock you would end up loosing 1/3rd of your total returns in addition to the transaction charges.
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On the other hand if the stock that you hold is not a good bet and has a dull future, then holding on to it for the reason that you suffered losses would only mean that your loss is going to increase further.
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However, the principle of 'Stop loss' (squaring of the position to protect against further loss) is not always a bad one. Especially if you are a trader or an investor with a very short terms perspective. Stock prices move in a very random fashion in the short run and therefore traders or short term investors necessarily need to inculcate the habit of stop loss.
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To conclude, a short term investor or a trader definitely needs to follow the principle of 'Stop loss' as a regular discipline. However, a long term investor should never decide on a sell vs hold decision based on the loss that has already been suffered since such losses are a sunk cost and cannot be recovered.
