The secret to creating lasting wealth, we are invariably told, is to let your winners run and not be tempted to sell them too early.

There must be thousands of people who invested in Apple (AAPL:NASDAQ) or Amazon (AMZN:NASDAQ) early on and were happy to cash in after doubling their money, whereas had they kept their original stake it would now be worth thousands of times the initial investment.

Yet there is very little advice on how to handle losses, which in fairness every investor no matter how experienced they are must expect to incur. Not even Warren Buffett gets every investment decision right, after all.

STEP AWAY FROM THE KEYBOARD

Stocks fluctuate all the time, more so than usual this year, so if you check your portfolio every day you are bound to find something which is down compared with where you bought it.

The less frequently you look at your portfolio, the less likely you are to see a negative performance and therefore the less likely you are to ‘tinker’ with it to try to avoid losses.

When you do check you performance, ‘the reward circuit in your brain gets activated and provides you with a jolt of dopamine as you anticipate a positive return’ says Joachim Klement, market strategist at Liberum and the author of Seven Mistakes Every Investor Makes.

‘The first time you see a loss you might shrug it off. The second time you might get concerned, especially if you happened to have a loss in your portfolio the last time you looked’, continues Klement.

‘Finally, if you experience too many losses within a short time, or if your losses are very big, the parts of your brain responsible for feelings like fear and anger kick in,’ he concludes.

We seem to be hard-wired to weigh losses more than we do gains of equivalent size.

As a result, when we do experience losses the ‘pain’ feels worse than the ‘pleasure’ we feel when we make gains, even if the gains are bigger.

A 2005 study by Camelia Kuhnen and Brian Knutson titled The Neural Basis of Financial Risk Taking shows that when we experience losses, the regions of the brain which control emotions of fear – like the amygdala – are activated.

THE FIRST CUT IS THE CHEAPEST

No investor gets every decision right, indeed many successful fund managers only have around a 60% to 70% ‘batting average’.

The reason they are successful is they right-size their winning bets and when they make a mistake they cut it quickly.

When Bill Ackman bought a stake in Netflix (NFLX:NASDAQ) in January following a sharp sell-off triggered by a profit warning, it was on the basis the valuation was attractive.

A couple of months later, however, the streaming firm warned again, sending its shares down even more, at which point Ackman sold his stake at a loss and moved on.

Investors may have questioned his original thesis for buying the shares, but they can’t argue with his approach to risk management.

Deep value investor Richard Pzena says the biggest way to add value as an investor is in how you treat 25%-plus drawdowns in stocks.

‘Sometimes you should buy more, sometimes you should get out, and sometimes you should stay put. We probably hold tight 40% of the time and split 50/50 between buying more and getting out’.

DON’T DO SOMETHING, JUST SIT THERE

In his largely autobiographical book on investing Simple But Not Easy, fund manager Richard Oldfield argues that doing nothing is sometimes just the right response.

In the opening chapter, entitled ‘Howlers’, Oldfield recounts investing in Russia just before the ruble crisis in August 1998 which caused the stock market to collapse by 90% in a matter of months.

After the market bottomed in October 1998 it doubled and doubled again, until by the end of 2005 in dollar terms it was worth 18 times more than at the end of 1998.

As Oldfield says, ‘it matters a great deal how investors react after a 90% fall. Something so devastating can lead to completely the wrong decision.

‘It is easy to say, when your $1,000 has turned into $100, “I can’t take any more of this, I would rather be sure of my $100 than risk losing that too”.

‘Selling at the bottom is a common fault, not surprisingly because the bottom in a share price is the moment of maximum fear’.

The ideal solution, suggests Oldfield, would be if the investor slept through the sell-off and was spared the emotional pressure.

In fact, Oldfield added to his Russian holdings – not quite at the bottom, but well below the level of his initial investment – and turned what could have been a thumping loss into a considerable gain.

DEER IN THE HEADLIGHTS

There are plenty of indications – and plenty of commentators willing to assert – that we may be in a bear market, in which case there is a danger of paralysis setting in.

James Montier, asset allocation specialist at US fund manager GMO and the author of The Little Book of Behavioural Investing, recalls that during the financial crisis, rather than running for the hills, many investors became paralysed in the face of continually falling prices.

‘In March 2009, the S&P 500 swooned to its lowest levels in a decade, down some 57% since its peak in late 2007. I watched as markets seemed to be near meltdown.

‘No scenario seemed to be pessimistic enough to be beyond belief among investors.’

Jeremy Grantham, Montier’s colleague at GMO, compared the same sell-off with a much earlier ‘crash’.

‘As this crisis climaxes, formerly reasonable people will start to predict the end of the world, armed with plenty of terrifying and accurate data that will serve to reinforce the wisdom of your caution.

‘Every decline will enhance the beauty of cash until, as some of us experienced in 1974, “terminal paralysis” sets in.’

Like the residents of Pompeii who watched Vesuvius erupt for days before reacting, investor paralysis results from a failure of imagination known as normalcy bias, argues Daniel Crosby, author of The Behavioural Investor.

‘Simply put, normalcy bias is the belief that “all that has been is all that will ever be”. Pompeii had seen eruptions before and the citizens imagined this time would be like the last time, until it wasn’t’.

The fact is, bull and bear markets are normal. Every developed country in the world has suffered equity market losses of at least 75%, says Crosby.

According to a study by analysts at JP Morgan, reproduced in The Behavioural Investor, between 1980 and 2014 almost half of all US stocks suffered what they termed ‘catastrophic’ losses. What investors need is a plan.

BUY OR SELL, DON’T HOLD

When investing you need to prepare for the unexpected so that if or more realistically when markets go into melt-down you have a ready-made plan of action.

Investors with an extremely long time frame, such as Richard Oldfield or the managers of say Scottish Mortgage Investment Trust (SMT), are willing to endure what for other investors would be ‘catastrophic’ drawdowns in stocks they own because they have high conviction that the firms themselves are still capable of delivering a superior performance.

In its latest results, Scottish Mortgage reveals it has raised another £500 million in private debt in order to increase its stakes in ‘higher conviction holdings’.

Not all investors are able to take such a long-term view, in which case stop-loss limits are a sensible precaution.

‘Stop losses may be a useful form of pre-commitment that help alleviate the “disposition effect” in markets that witness momentum’, says Montier.

Investors typically sell more winners than losers, so when a company releases positive figures and the shares go up people sell, limiting the true upside, while if a company releases bad figures and the shares fall many investors will shy away from taking losses and hope the price will recover.

Stop losses can act as triggers ‘to prevent you sliding down the slippery slope of the disposition effect’, offers Montier.

Another way to envisage stop losses is to imagine you own a stock which has lost 30% in the last three months, which admittedly isn’t difficult in the current environment.

Then imagine you step away from your computer and your toddler inadvertently sells your entire position.

Would you buy the shares back? Almost certainly not. Thinking about stocks purely in terms of buy or sell is a good way to sharpen your skills. If you wouldn’t buy more of a stock when it is down 30%, why are you holding onto it?

DISCLAIMER: The author (Ian Conway) owns shares in Scottish Mortgage Investment Trust

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