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July 1, 2014

Cut Your Losses

by alive

I have a friend. Let’s call her K. K is a really good worker, honest and responsible. The problem is an unappreciative and egomaniacal boss who derides her efforts, passing her for promotion after promotion. She has become so numbed by the situation she doesn’t realize just how much she’s lost in terms of emotion and opportunity. As time goes on, she’ll continue to be drained, but also encourage the bullying behavior of this boss.

 

Desperate friendI have another friend. Let’s call him J. J is the stereotypical nice guy who doesn’t have a clue about women. Recently he’s been after a girl, doing nice thing after nice thing in the hope that she will eventually be moved by his sincerity and give him a chance. He doesn’t understand that 1) she’s just not interested and 2) each embarrassing attempt he makes is only going to hurt his emotions, his ego and his reputation more, without anything to show for it.

 

 

These two friends remind me it’s time for another lesson from investing. Today’s idea is going to be easy to understand conceptually, but hard for many to do. Yet it’s perhaps the most important one in this series.

We’re going to talk about cutting losses early.

 

The Setting

 

Have a look at the following chart for EDMC. Say you bought it near the end of January for $10.90. Immediately after, it starts to drop. At which price would you sell it?

 Edmc1cropped

 

If you’re like the masses, you probably wouldn’t do it if price fell by 1% (Price $10.80).

After all, if it’s dropped by ‘only’ 1% (10c), you haven’t lost much, and all you need is for the stock price to rise 1% and you’re back where you’re started.

 

What about 2% (Price $10.70)? Would you sell here?

Edmc2cropped

Again, many people look at that ‘tiny’ percentage and decide to hold. In fact they might not even notice it.

 

What about 8%? (Price $10)

 Edmc3cropped

At this stage people start to take notice, but they are reluctant to sell because it would mean realizing an 8% loss of their investment. They have now lost a significant amount so they feel compelled to hold on, hoping to breakeven when the price rises again.

 

 But let’s look at what it takes to recover from ever increasing percentage losses.

 Breakeven Percent

What you notice is when percentage losses are small, an almost equivalent percentage gain gets you back to even. But as percentage loss increases, the gain required to breakeven grows at a faster rate. If your stock lost half its value, it will have to double to break even.

[As with our last article, transaction costs are ignored for simplicity]

 

Here’s the counterintuitive takeaway.

 

The smaller your initial loss, the more reluctant you will be to sell.

 

Yet, a small loss is when you should sell because it can snowball to irreparable disaster if you don’t know when to quit!

 

Why It’s Hard to Quit

 

Why is it hard for investors to sell a losing position? Here are some reasons

  1. Admitting mistakes. No one likes to admit they made a mistake, especially soon after committing to a position.
  2. Paper loss and hope. As long as they don’t sell, people still consider it a paper loss. It’s not a real loss of capital until it’s sold. They hope that there’s a chance the price will recover.
  3. Distraction by success. When other stocks are doing well, so that the overall portfolio shows a profit, it’s easy to forget about the one or two stocks that are bleeding red.

 

What to Do?

 

Here’s how successful investors make cutting losses a little easier.

  1. Set a stop loss order. This is an automatic order set up with the broker to sell a stock if it hits a certain percentage loss. For example, setting a stop loss order for 10% means that if the stock price drops 10% below your purchase price, it will be sold immediately.
  2. The magic “Would I now” question. When in doubt, ask yourself this question: If I didn’t already own this stock, would I buy it right now?” If the answer is “No”, sell it.
  3. Analyse individual parts of the portfolio. Don’t just look at your total gain or profit. Look at individual stock positions and decide on a case-by-case basis what to do.
  4. Remember opportunity cost. With every decision you make, you give up an opportunity elsewhere. Money stuck in a losing position is money that could be put into another stock.

 

By the way, in case you’re wondering, here’s what happened to EDMC

 Cutting Loss Early

 

With that background, let’s look at how the concept of cutting your losses early can be applied to two important areas of Life – relationships and work. In addition, I want to end off by talking a bit about how it should be applied to Life in general.

 

 

Relationships

 

Relationships are fantastic. The right one with the right person is one of the best things that can happen in Life. The wrong one can destroy it. Many toxic situations drain time and resources. In the intro I mentioned my friend J, chasing after a girl who can’t be bothered with him. Some people are in unfaithful, parasitic or abusive relationships. In all these cases the person is likely to end up with lots of hurt, lost dignity, and wasted time and emotion.

 

The idea behind cutting your losses is to set definite rules in place, and this can apply to relationships too. That way, you will avoid averaging down until you are forced to stop by something you may not recover from.

 

Why It’s Hard to Quit

 

Relationships are charged with emotion, and once people have invested it it’s hard for them to let go even if it’s no good for them.

  1. Admitting mistakes. In a relationship, it takes a lot of courage to ask for a number, a date, or even announce to  friends that you have decided to make a commitment. To back out so soon invites judgement, and maybe even a guilty suspicion that you didn’t try hard enough.
  2. Paper loss and hope. People argue that as long as they don’t end a relationship or cease a pursuit, they still have a chance for a happy ending. A typical example is the on-again-off-again relationship. As long as there is some tie of sorts, it’s not over. Another example: an ardent pursuer fixates on the fact that because his text messages are replied to, he’s still got a hope. Whatever losses (such as wasted emotions, roller coster connections, and dented pride) are just paper losses; walking away would be ‘realizing a loss’ and eliminating all hope altogether.
  3. Sad career womanDistraction by success. Sometimes, when other areas of Life are going well, it’s easy to forget there is too much energy leak from one area which can contaminate the rest. This is why you see the puzzling phenomenon of a successful career woman with her relationship in shambles or an otherwise intelligent man ruining his Life by one bad relationship.

What to Do?

 

  1. delete numberSet a stop loss order. Decide beforehand what your acceptable ‘loss’ will be. For example, how many crazy outbursts from a girl will you accept before you leave the relationship? In the case of physical abuse, I suggest that number be set to 1 before you run and apply for a restraining order. My friend J might set a limit as to how cold reactions he will get from a girl before deleting her number and moving on.
  2. The magic “Would I now” question. When in doubt, ask yourself this question: If I wasn’t already in this relationship, would I get in now? If the answer is “No”, leave.
  3. Analyse individual parts of your Life. Are you ignoring negativity in your relationships because other aspects of Life are going well, thereby making it easier to bear? Instead think about how much better it would be if your relationship was as great as the rest of your Life. And if the other aspects of your Life need fixing, a draining relationship is the last thing you need.
  4. Remember opportunity cost. Instead of being in a draining relationship, could your emotions and efforts be better off in a more loving one? Instead of wasting time chasing a girl who doesn’t appreciate your efforts, why not give those who are interested a chance?

 

 

 

Work and Career

 

Work, be it holding a job or running a business, takes up a huge proportion of our waking hours. It is how most of us make our living, so it’s very hard to leave because leaving would threaten our sense of stability.

 

Why It’s Hard to Quit

  1. Admitting mistakes. One of the most significant milestones in your Life is getting a job. It’s one of the decisions we sweat hours pondering over, and in which we are acutely aware of the concept of opportunity cost. It’s tough therefore, to make a decision, cut off other options, and then realize early on the job doesn’t fit.
  2. Paper loss and hope. People argue that bad bosses, bad colleagues and unfulfilling work are just paper losses (transient), as things may improve if they continue to work hard. Furthermore, people can get numb to it after some time. Quitting a job means realizing loss of income and stability.
  3. Distraction by success. Often, people who are bullied at work are nice people, which means they have a good support system of family, friends, and loved ones. It’s so easy for them to leave work, be showered with love and friendship outside as a recharge, and then be ready to hit another day at work again. The fact that Life is great outside of work makes work itself more bearable.

 group hug

What to Do?

 

How would you approach a job situation using the ideas discussed here?

 

  1. Set a stop loss order. You need to decide beforehand what your acceptable ‘loss’ is going to be. For example, how many times will you accept being passed over for a deserved promotion? How many more days of a ‘temporary’ situation your boss has asked you to tolerate before getting that new staff, dropping that nasty client etc will you take as a maximum? In my friend K’s case, we set two-stage goals. First stage: we agreed on two more outbursts before she spoke to her boss about his behavior. Second stage: We agreed that if that talk didn’t go well she would immediately start accepting job interviews and make leaving that job her primary goal work-wise.
  2. The magic “Would I now” question. When in doubt, ask yourself this question: If I wasn’t already in this job, would I sign up now? If the answer is “No”, start prepping that resume.
  3. Analyse individual parts of your Life. Are you ignoring your work situation because after-work activities or relationships act as temporary panaceas? For example, while work sucks, you know that your boyfriend is there to give you a hug. Instead think about how much better your relationshisp could be if you were in a better mood or state after work, or if you were discussing other aspects of Life instead of how bad work was.
  4. quit jobRemember opportunity cost. Be it a job, in which your shelf life decreases with each passing year, or your own business, in which continuing a losing enterprise robs you of resources with which to start afresh, the opportunity cost of hanging on is huge. If your current situation is bad, consider using your remaining reserves of energy, emotion, and money, for something else. Staying in your comfort zone dwindles your chances of starting afresh elsewhere.

 

 

It’s about Loving Your Life

 

I know the idea in this article might seem harsh. Even the phrase “cutting your losses” has a mercenary ring to it.

 

Energy DrainThe fact is: many things in Life drain us of energy. Of motivation. Of love. Of effort. You might not see it at the time, but over the years, you’ll realize how that little project that wasted three months of your Life when you were 33, that bad relationship that drained you for 8 months when you were 25, all added up to precious time and energy that could have been used so much better.

 

Even little things you do for the sake of completion take away from your resources and happiness. Maybe it’s a lousy book you started and felt compelled to finish. Maybe it was five minutes into a class and you knew it wasn’t what you wanted. It might even be a dish you ordered that tasted awful.

 

Cutting losses is hard to do, but in the long run, it is the best thing. Give your resources only to things that give back, not in a one-sided way that simply drains you empty. The experiences of many has consistently shown that often, you realize early if a road you have taken is good or bad. The big mistake is staying too long.

 

In many ways, this article in this series is the most important. By using some of these ideas, you’ll not only be more alert to when a bad situation might become worse, but also recognize if you’re already in one.

 

Then cut your losses, and move on to something better. Your Life will be happier and more fulfilling for it!

 

The challenge is, DO YOU LOVE AND RESPECT YOURSELF ENOUGH?

 

Are you serious about making your Life the best it can be?

 moving on quote

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