Posted on November 30, 2009 by Ben Connard
I was talking to a friend about his portfolio. He has a big slug of Pfizer. I told him he should reduce it to about 4% of his equities. He said he couldn't because it was at a loss. So what?
Investors don’t like to sell positions at a loss. It’s depressing and is essentially admitting a mistake. However, whether you are holding a security at a loss or gain is largely irrelevant, ignoring the tax consequences. What’s important when evaluating a security is whether you believe it’s currently undervalued and how that valuation compares to your other options.
Let’s say you have a fully invested portfolio of 25 securities, including PFE at a cost basis of $20. It currently trades at $18. You evaluate your other 24 options and discover that PFE is the least undervalued—in other words it’s trading the closest to its intrinsic value. While your analysis indicates it’s worth $22 (a 20% discount) you believe your other holdings are currently trading at a 25% or more discount. In addition, you have a new security you’d like to purchase because you feel it’s trading at a 50% discount. I’m assuming you will not be going into margin.
You need to sell something. PFE is the logical candidate but you sell something else so you don’t have to go through the mental pain of realizing a loss. PFE appreciates 20% and then you sell it. Now you feel good—you avoided the loss and even made some money. However, the holding you sold instead of PFE appreciated 25%. In essence you actually cost yourself that 5% by refusing to sell at a loss.
In addition, if this was a taxable account, you’ll have to pay gains on the original sell. If you had sold the PFE, you could have used the loss to offset gains elsewhere. The overall performance of your portfolio is more important than the individual performance of each security. You could have a positive return of 10% on each holding, but it’s better to have an overall return of 15% even if it’s made up of 10% losses and 40% gains.
Of course, the opposite is true. When a stock gains 40% investors will get attached and hold on to it well past its prime. Again, if a security has a large gain it doesn’t mean it will continue going forward. It’s the old adage: past performance is no guarantee of future results. Many times when investing, emotion needs to be removed from the decision.