“In this business if you're good, you're right six times out of ten.”
It doesn’t feel like it should make sense, does it?
How can you be a good investor and get your stock picks wrong nearly half the time?
In any other business that would take some explaining. “I know the house is flooded but just over half of those pipes are working beautifully” won’t cut it.
And that 60% is if you’re one of the best out there.
Lynch’s Magellan Fund outperformed the S&P 500 in 11 years of his 13-year tenure from 1977-1990, with an average annual return of 29%. Safe to say he gets into that elite crowd.
So, how do you get that kind of return and still have around 40% of your portfolio in the red?
Investing doesn’t stop at the buy button
As much as we’d like it to be a cut-and-dry case of sorting the winners from the losers, investing isn't quite like that. It’s not a game of waiting for that one fateful roll of the dice and then being stuck for life with whatever a stock does next.
As George Soros put it, “It's not whether you're right or wrong, but how much money you make when you're right and how much you lose when you're wrong.”
That makes it less important to focus on the initial share price reaction after you’ve bought, and much more integral to manage whatever you do next. This is where the best investors in the world shine.
If at first you don’t succeed, buy, buy again?
We all go through a strange rite of passage the first time we see an investment go south. An instinctive rush to the exit is normally quashed by something we heard about it not being a good idea to sell straight away.
Short-term falls are part and parcel of investing after all and if you wait it out it’ll be fine, right?
The thing is, not all stocks are like Tom Daley, using past disappointments to ultimately come back with a gold medal-winning performance. Some companies might do a bit of soul-searching and come back strongly, others you’ll just watch wither into the ether.
So, which one is it - hold or sell? Should you even buy more? Most of us have gone in circles asking ourselves these exact questions.
Buy companies, not stocks
The trouble with this, and the reason we end up in limbo, is that we focus on the wavy line on the screen and not the company behind it.
We tend to concoct one-size-fits-all solutions for ourselves based on what the charts are doing but every company and every driver behind a share price fall will be different.
Once you factor in what is actually happening on the ground and not just on the market, it becomes a lot clearer whether holding, selling or loading up is the right thing to do.
The nice side of selling
Knowing when to sell on the way up is arguably a much more comfortable decision to make.
You might have been waiting for an announcement like a mining firm winning a license to drill, or a biotech announcing its drug has passed trials. Risky business but, ultimately, triggers for a lot of sell orders among investors.
You might have already scheduled some regular sales to take a bit of risk off the table as a stock rises.
But, going back to Soros’s point, if your company is exhibiting all the hallmarks of a quality outfit (consistent earnings and returns on capital above what the market is achieving, low levels of debt and strong fundamentals) why would you want to get rid of it?
If the business does well, the stock should eventually follow, according to Buffett, which means it might be worth hanging onto.
And here lies one of the key reasons you don’t need a 100% hit rate. Running those winners can be so beneficial that it makes up for the laggards elsewhere in your portfolio.
Lynch points to his ability to let the best firms in his arsenal simply keep on going as a huge contributor to his success. He made the conscious decision to hang onto underwear firm Hanes after his wife declared its pantyhose the best in town.
When it was bought out by Consolidated Foods (now Sara Lee) he had achieved a 10x return on the stock and said it might have returned 30x his original investment had it not been taken over.
The point he was clinging to was that, despite short-term news shaking share prices, over the long term, earnings and fundamentals drive share prices. When you find a good example of those working in tandem, it’s hard to think about selling up.
How to sell at a loss and keep your sanity
That’s the nice side of selling. The thought of getting rid of a stock when the numbers are red can be nauseating though. But if we really asked ourselves why that is, a big part of it is ego and not wanting to be wrong.
A lot of investors want to be the person that swells their wealth because they saw what no-one else did, then humble-brag about it, given half the chance. Getting one wrong doesn’t fit that narrative.
But if you can get past the emotional side, selling at a loss can be a real saving grace.
You can run your winners all you like but if you run your losers too your portfolio is essentially fighting against itself.
“Just when I thought I was out, they pull me back in.”
If the investment case for the company has changed from the one you bought into, staying put would mean hoping for a turnaround from a firm you wouldn’t have looked at twice in normal circumstances.
That’s actually a good question to ask yourself if you’re considering topping up a holding that has dipped. Would you have been drawn to invest in the firm if you weren’t already in it?
If the answer is yes, you’re getting shares you like at a lower price. If not, why are you in it at all?
This is when the best investors make that choice and move on. They know they don’t have to get every stock pick right and limiting losses at this stage can be just as helpful as gains elsewhere, for the good of the overall portfolio.
A string of profit warnings amid its transition from paper to digital put him in that classic position of deciding whether to get rid or hang in there.
Ultimately, he chose to stay put because he backed the long-term prospects, even if the short-term turmoil was keeping him awake at night.
The important takeaway here is that he delved into the business itself and didn’t try to divine any grand revelations from watching the share price.
On that note, try not to get stuck watching a stock fall, in the hope it will suddenly correct course. Even if it does, you’ve left yourself open to huge losses when you could have bitten the bullet earlier and reinvested somewhere else.
Again, the stock doesn’t owe you a turnaround no matter how much you want it, sometimes you have to chop it off for the good of your other holdings.
That’s a good prompt for another Lynchism, “Selling your winners and holding your losers is like cutting the flowers and watering the weeds.”
If you constantly snipe at minor profits and hang around for the losers to come back up, you’re essentially penalising your best performers and giving the duds permission to keep losing you money.
You don’t need to be right, you need to be prepared
In short, we should do our best to let the winners run when the fundamentals back them up, and interrogate a falling stock. Is it genuinely a short-term blip or has there been a change in the fabric of the business?
There can be logic behind riding out short-term volatility but it needs to be different from getting frozen in front of the headlights. When it comes to it, you’ll know which side of the coin you come down on.
How do you tackle a losing stock? Do you have a process in place to keep the emotion out of things? Let us know on the community forum:
Freetrade is on a mission to get everyone investing. Our stock trading app makes it easy to buy and sell a wide range of investments, including stocks, ETFs, investment trusts, REITs, SPACs and even newly launched IPOs. Take a look at the most traded shares on the platform to see what retail investors are buying and selling.