Benefits of Adding to a Loser
In the context of the preceding sections, it is crucial to acknowledge that supplementing a losing investment may still prove to be a prudent decision. In specific scenarios, adding to a struggling position may demonstrate that it was indeed the correct course of action.
Investors have the opportunity to decrease their average cost basis by adding to a losing investment at a reduced price. Ultimately, this can enhance the overall return on their investment. Additionally, it can amplify the potential for future profits, as investors often adopt a long-term value approach when considering further investment in a losing position.
Furthermore, capitalizing on market inefficiencies can create favorable opportunities, particularly when a stock or asset experiences a decline due to short-term market sentiment or external factors. By seizing these inefficiencies, investors can potentially benefit from subsequent corrections or rebounds. In these contexts, the decision to invest in a losing position may be more rational compared to emotionally-driven traders who impulsively trade based on short-term sentiment.
Strategic portfolio allocation can also involve adding to a losing investment. If an investor has a long-term investment horizon and a diversified portfolio, they may allocate a small portion of their capital to high-risk investments, including some losing positions, to recognize the potential for higher returns in riskier assets. Depending on the overall movement of the portfolio, the investor may choose to reallocate funds into riskier assets to maintain a specific portfolio allocation. Although this approach may entail taking on more risk due to the struggling investment, it may prove to lower risk in other contexts due to the nature of a more diversified portfolio.
Illustration of Adding to a Losing Investment
Let’s consider an example where an investor observes a previous uptrend and waits for a pullback, purchasing 100 shares of stock at $32 in October. The investor intends to hold this position for the long term, and the trade costs $3,200.
By January, the security’s price has dropped to $16. Consequently, the value of the position is now half of its original value, amounting to $1,600. Despite this decline, the investor decides to continue adding to the position.
The core issue lies in the fact that most individuals desire and require security in all its aspects, yet “trading is the most insecure business one can engage in,” according to Welz. He contends that no other occupation elicits such a multitude of intense emotions and mirrors our personalities to such a great extent. Welz even goes to the extent of asserting that stock market activities embody money: “We are not merely trading assets and money, we are embodying the money.”
To engage in trading successfully, possessing the correct mindset is crucial. However, nothing is more challenging than detaching ourselves from the various influences that have shaped our mindsets and determine how our brains operate. We are shaped by our parents, family, friends, environment, society, media, literature, and more. By the time we enter the trading arena, all these influences have typically ingrained trading patterns that are frequently dysfunctional or suboptimal. Attempting to alter these patterns is a daunting task.
Why Do Traders Overlook the Influence of Psychology?
To grasp Welz’s perspective, it is imperative to recognize the significant role of psychology and the brain. While the idea that psychology plays a crucial role in the stock market is not groundbreaking, Welz contends that trading is essentially 100% psychology. Without a functioning psyche, we would be unable to assess financial risks or identify trends. “No brain, no stock market trading,” asserts Welz.
Therefore, mental fortitude is absolutely essential for achieving success in trading. Moreover, approximately 95% of our actions are subconscious, leading us to replicate our behaviors repeatedly. Unfortunately, this replication often involves repeating incorrect or even disastrous courses of action.
