If you invest in the shares of individual companies, I reckon it’s important to keep a close eye on them. Single-company shares have the potential to outperform the general market indices, but they can also underperform.
And I think one of the most important ingredients of successful investing is to protect your portfolio from big drawdowns if you can. “Don’t lose money,” Warren Buffett urges us. And one way of guarding against big losses is to sell shares when you realise you’ve made a mistake.
Warren Buffett did that with his investment in Tesco a few years back. The share price moved against him and he realised he’d lost his confidence in the firm’s management. So he sold his entire holding for a loss of millions. But his loss could have been larger still if he’d held on to the declining shares.
Well-known British investor Lord John Lee told us he’d introduced a stop-loss rule to his strategy in recent times, set at about 20%. If he buys a share and it moves the wrong way, he’ll cut the loss at 20% or so and acknowledge that he made an error. And investor/traders such as Mark Minervini have been banging the drum for years about their strict stop-loss strategies.
Here are three wealth-destroying investing mistakes I’m determined to avoid in 2020 and beyond.
1. Not cutting losses
It’s always tempting to hold onto shares after we’ve bought them even when they start to slide. One of the big fears is they may turn around and shoot back up as soon as we sell out.
But not stopping a loss by selling can sometimes have big financial consequences. For example, Pharos Energy has looked good on paper to many investors for a long time, but the shares have declined by more than 90% over the past six years.
Cutting the loss early would have been a good idea in the case of Pharos Energy. And because we can’t tell which shares will recover and which ones will continue to plunge, for me, the best idea is to always cut losses.
2. Averaging down
Some investors buy more shares in a company if the price moves against them. But if you do that you are really betting that the shares will rise again based on your own assessment of the fundamentals and prospects for the business.
Consider this, though. You’ve already completed a purchase based on your opinion and have been proven ‘wrong’. If you repeat the process you could be wrong again and end up increasing your losses. I reckon the safest approach for me is to never average down on a losing share.
3. Catching falling knives
Investing in falling share prices – or falling knives as many have become known – usually involves taking a contrarian view about a company experiencing difficulties of some kind. But such an approach means you’re hoping for an operational recovery in the underlying business. And it’s easy to be wrong in your assessment, so I’d avoid these types of situations altogether.
Kevin Godbold has no position in any share mentioned. The Motley Fool UK has recommended Tesco. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.