by Tom Doan
When investing in the stock market, most people will say that the goal is to “buy low and sell high.” In a perfect world, everyone would stay true to this and the stock market would only go up. However, this is not always the case. Equal probability states that stocks have a 50-50% chance of increasing or decreasing in value. As a result, the stock market will often not move in a desirable direction, decreasing the value of the portfolio. Investors may ditch the “buy low and sell high” mantra, panicking because of the loss in value and dump the stock. Their emotions caused them to do the exact opposite, “buy high and sell low.”
In the Snider Method, a position can decrease in value and enter a state called “winter,” where the value of the stock has decreased to the point where income can no longer be generated. Clients will occasionally ask me if they can liquidate and sell these positions that aren’t generating income because they are afraid it will either go bankrupt or be inactive for years to come. But is this a good idea? Let’s look at the potential consequences in detail.
If the average cost of a position is $28 but it is currently trading at $5, selling 1,000 shares would result in $5,000 cash with a loss of $23 per share, realizing $23,000 in losses. Clients who have a fear of bankruptcy focus on the $5,000, rather than the $23,000. You are only able to recoup a small portion of the amount invested. Clients will usually say that $5,000 is better than $0 when, and if, it goes bankrupt. However, of the thousands of positions we’ve traded over the years, only a very small handful have gone bankrupt. Thus, if a position goes bankrupt, it is a very rare occurrence. In addition, with equal probability, the stock is just as likely to go from $5 to $0 as it is to go from $5 to $10.Even if the stock goes completely bankrupt, the amount you lose is an additional $5,000, which you would have redeemed (a $28,000 loss vs. the $23,000 loss). This is the maximum that you can lose since the stock cannot go below $0. On the flipside, the potential gain is much greater than $5 per share. This is why we would rather keep the shares and hope it eventually increases in price, the potential gains outweigh the loss if bankruptcy occurs.
If you sell shares, you have converted equity into cash. As a result, that portion of your portfolio will no longer fluctuate in value with the stock market. If you sell a position and the stock increases to $10, you miss out on the capital appreciation because you are no longer holding those shares. However, the emotion of fear causes investors to blindly focus on the downside and disregard or downplay the potential upside. Although it is difficult to see a stock depressed in value sitting in your account, by looking at the consequences of selling, the most logical course of action is the one your fear doesn’t want to do: holding onto the shares.
