When to Break Up with a Losing Stock

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In an article last week, I talked about how the stock market is a rollercoaster and you shouldn’t get off the ride in the middle— and that is 100% true. However. You also need to know when to cut your losses; and sometimes that will mean selling a stock for less than you bought it for.

I know what you’re thinking. You’re thinking “Lapin— wait… So far, the strategy for buying low and selling high has been about playing a long game. Like, dollar cost averaging is all about making investment contributions over time, right? Capital gains taxes are all about holding onto investments for over a year. And you just told me not to get off the roller coaster… Now you’re changing your tune? What the hell?”

Okay, so yes— all of these things are true, but holding onto a stock is only the right move if you are sure that you’ve made a good investment.

Here’s the key: the market plummeting means something entirely different than an individual stock price plummeting. As I mentioned in last week's article, the market is very good at rebounding; but the stock value of failing companies won’t rebound, they will just… fail.

If the market crashes it could be due to a multitude of reasons—a war, an election, a pandemic, something that makes Americans feel that the future is uncertain. A market dip doesn’t necessarily mean that the stock market is failing, but more likely indicates a rough financial time across the board. A dip in stock price, on the other hand, could be due to fundamental problems with the company you invested in. There are bad times and bad investments. Don’t confuse the two.

When exactly you cut your loss is up to you and your risk tolerance. Just don’t fall for what we call in the biz: the breakeven fallacy. Let me back up for a second. A really common mindset with investors is that if they see a stock price tank and decide to sell, they assume the price will recover a bit (which, to be fair, does happen). So, they say they’ll wait until the stock gets back to the price they bought it for, then they’ll sell. That’s the breakeven fallacy. And it’s exactly that: a fallacy.

The problem with this mindset is that people don’t do the math correctly when thinking this over. They think: "Damn, my stock has gone down 30%, shit. So it needs to rebound 30% in order for me to break even, not great, but stranger things have happened? Right?"

Wrong-o. I know it doesn’t immediately make intuitive sense, but let’s double click on an example: if you lost 30% on an investment, the stock price would actually need to rise 43% before you broke even.

Take it from someone that’s pretty clumsy: falling down takes a whole lot less effort than climbing up, and the same is true for stock prices. The further the price of a stock falls, the harder it’s going to have to work to climb back up to the point where it fell. Let’s look at an example with a bigger drop: if a stock falls 50%, how much does the price have to rise from that point before you break even? 100%! In other words, if you lose 50% on the value of a stock, the stock price is going to need to double in order for you to breakeven— and the more you lose in an initial dip, the longer it takes to break even.

xo,

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