To hold loss-making positions or not to hold, that’s the question

It has been a painful journey for most investors since January 2008 what with equity values declining more than 50 per cent. An issue that investors are battling with currently is whether to close their loss-making positions and move into cash or to hold on to the positions. And then, what if asset prices decline further?

This article discusses these issues. It suggests the need to divide the portfolio into two and explains the circumstances when holding on to the positions may be more optimal than taking losses.

Loss aversion


Most investors are currently saddled with large unrealised losses because they suffer from loss aversion. This refers to a behavioural bias that prompts investors to hold on to their losses for too long and to take their profits too soon.

That said, all investors have a threshold loss tolerance level. This is the level beyond which they cannot bear losses on their portfolios. The loss tolerance level is a function of the asset size and income stability of the investor; large asset size and stable income provides for higher loss tolerance level.

If investors are well past their discernible loss-tolerance level, they should cut losses on their portfolios and move into cash. This article is, however, not about such portfolios. Instead, it discusses unrealised losses on portfolios where investors are not compelled to move into cash. The question then is: Should these investors also cut their losses? Or should they simply follow a buy-and-hold strategy?

Market timing

Let us suppose asset prices have a downside of 30 per cent. It would be logical for investors to move into cash now and buy stocks after the market bottoms out.

But this argument presupposes that investors can find the “right” time to roll back into equity at a later date. If they could not “time” their exit last year, it does not seem logical to assume that they can “time” their entry back into the market in the future.

Some may argue that investors can still save themselves losses if they cut their position today and roll into equity at prices 10 per cent lower. The argument is correct provided investors are disciplined.

Evidence suggests that investors become conservative after they realise losses. They typically move into nominal-capital-guaranteed securities such as term deposits with commercial banks. Inertia then sets in, preventing them from switching back to stocks after the market turns. And that could prove sub-optimal in the long run, as conservative investments typically do not beat inflation.

Buy and hold?

This does not mean that portfolios have to carry all the losses. Investors should instead look to creating a core-satellite structure on their existing portfolio.

The core portfolio is a low-cost beta exposure to the market. Investors should move large-cap stocks or index funds in their current portfolio to the core portfolio. This portfolio, set-up to achieve a defined investment objective such as buying a house, will not be rebalanced to cut losses. This strategy is also based on evidence that large caps typically rebound faster than mid-caps and small-caps when market turns.

The satellite portfolio is the exposure that generates current income through superior security selection and market timing. Existing stocks not moved to the core portfolio will be part of the satellite portfolio. It is this portfolio that has to be rebalanced.

If investors are of the view that stocks in this portfolio carry a downside of more than 10 per cent, it would be optimal to cut losses and move into money market funds that carry exposure to T-bills, call money and CPs. This money can be rolled back into equity at a later date.

Conclusion

While it is painful for investors to watch their portfolios lose value, moving entirely into cash may not be optimal at this point in time. Investors can consider holding their loss-making long-term (core) exposure and cutting loses on their satellite portfolio.