Never Throw Good Money After Bad

A successful self trader – Rule # 8

Most people do this; either knowingly or unknowingly. Throwing good money after bad is done in a variety of ways. You can either average a bad investment decision. Alternatively, you decide to exit a quality stock and invest in a company with dubious credentials. Worse still, you stay too long in loss making positions and exit rapidly from profitable positions. Don’t throw good money after bad!

No good money after bad, please…

More than a decade ago, a young enthusiastic advisor in a brokerage house had recommended to a client to dispose of his holdings in Hindustan Lever and re-allocate the entire proceeds into DSQ Software. The argument was simple; Hindustan Lever is a laggard and DSQ is the stock of tomorrow! To add to his confusion, DSQ stock doubled in the next one month.

When the agitated investor had called seeking our advice, we had advised him not to throw good money after bad. Of course, the stock of DSQ went up further and Hindustan Lever continued to languish. But the entire scam unfolded over the next few months. DSQ eventually lost more than 99% of its value before getting suspended and ultimately delisted. What remains of DSQ, is just a shell!

One can imagine the anxiety of the investor as he saw the stock of DSQ rising. But one can also imagine his subsequent angst, had he sold of his Hindustan Lever shares to enter into DSQ. He would have not only lost out on the subsequent growth story of Lever and the dividends, but would have ended up holding worthless paper in his hands. Fortunately, he had a happy ending!

3 CLASSIC TEMPTATIONS TO THROW GOOD MONEY AFTER BAD:

But, my stock is going nowhere…

This happens all the time. Your blue chip MNC is stagnant and that unknown entity in the IT, biotech or alternative energy space is going up by leaps and bounds. Never ever dispose a quality stock and reinvest in a speculative stock.

If it is bad, then it should get better; Oh really…

Not necessarily though! Remember the old saying, “Cheap crap is crap anyway”. Just because, a Kingfisher or Deccan Chronicle loses 95% of their value, it does not make them attractive. It just proves what they are worth!

Hope and panic in the wrong place…

Most traders get this wrong. They exit profitable positions fast to realize the profits. But they hold on to loss-making positions for too long in the hope that a bounce will happen. Why to throw good profits after bad losses?

“Faced with bad choices, investors take desperate gambles as small hope overpowers high probability of losses” – Daniel Kahneman

6 RISKS OF THROWING GOOD MONEY AFTER BAD…

  1. You commit the same mistake twice. Take the example of Nick Leeson of Barings in 1995. Faced with losses in his options positions, he sold more and more strangles on the Nikkei just to show inflows. When the Nikkei imploded so did his position and so did the 200 year old Barings of London.
  2. You let your faint hope overpower the probability of losses. Remember LTCM in 1998. The Nobel laureates had probably understood that their calculation had gone awry. Instead of unwinding their spread positions, they kept adding in the hope that eventually sanity would return. It was just too late!
  3. You overexpose yourself to a particular position or theme. I remember investors who had kept averaging Larsen and Toubro back in 2010 in the hope that it would eventually bounce back. Sadly, the capital cycle had turned negative and the bounce never came. Eventually overexposure killed these investors.
  4. You reject a proven performer for an unproven fad. It happened so often to Indian investors. Trying to ride the bandwagon of technology, cement and real estate stocks, has forced many long term investors to give up on their proven blue chips. When the fad vanished, so did their money, and all the pedigree!
  5. Not everything that falls manages to bounce back. People cite the example of Infosys which eventually recovered all the losses of 2000 and more. But Infy is the exception that proves the rule. When you buy stocks lower in the hope of a bounce-back, more often than not you live in a fool’s paradise!
  6. Finally, there is the negative fallacy. Some of the finest traders like Jesse Livermore have emphasised the need to just exit when you go wrong. On the other hand, the likes of Buffet, have focused on letting their correct calls to the fullest. Sadly, most investors tend to do exactly the opposite.

THE PSYCHOLOGICAL BASIS OF “GOOD MONEY AFTER BAD”:

Your ability to think rationally, is effectively tested in a desperate situation. Sadly, that is exactly when it fails you. Given a choice between remote hope and apparent reality, there is a tendency to rely on hope. Most investors and fund managers are loath to accepting the erroneous investment decision in the first problem. That is responsible for escalating the problem into a full-blown crisis.

A leading fund manager once casually mentioned that in India, the stigma with wrong investment decisions is quite high. Secondly, historically most Indian companies that have corrected have managed to bounce back and fund managers tend to gamble. In the process they tend to forget a basic fact. The money released by exiting a pointless investment can be fruitfully deployed in another stock with better prospects and better returns. That would be compensation enough!

TAKEAWAYS FROM THE “GOOD MONEY AFTER BAD” DEBATE…

As the legendary investor, Jesse Livermore, rightly said, “The only right thing to do when you are going wrong, is to stop being wrong.” That is exactly what investors never do. It could be partly explained by the fact that there is too much emphasis on conviction in investing. An investor who changes course midway is looked upon as a fickle-minded investor. Nothing could be farther from the truth! In fact, by changing course, you may have just avoided throwing good money after bad.

Great investors like Warren Buffet and Peter Lynch have also thrown good money after bad. It is just that they realized it sooner and embarked on a course correction. When you throw good money after bad, you distort your investment concentration, forsake long term value for the sake of short term gratification and allow emotion to get the better of our judgement. As Lynch said, “You do not need an awful lot of multi-baggers in life to get rich. Just ensure to throw enough money on them”.

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