How To Tell if You Were Wrong About a Stock

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An important, if painful, part of investing is reviewing your losing trades to figure out if and why you were wrong, according to Real Money Columnist Paul Price.

“Seeing stocks you own and like go down significantly is disheartening. It can make you wonder if your investment thesis was faulty,” Price wrote recently on Real Money. “When you can go over all available data and find nothing but good news, however, what do you do? Smart traders average down or re-initiate positions at the now heavily discounted quote.”

Okay, so let’s translate that.

One of the problems with trading on the fundamentals is that sometimes the market just disagrees. You find a great company, with a great product and great leadership. They have strong cash flow and profits, with plenty of growth ahead, so you invest. You hold onto your shares expecting other investors to agree and buy in, which would in turn push the stock up and reward your investment.

But they stubbornly don’t. For some reason no one else sees what you saw in this business. The stock price doesn’t climb or, worse, it dips.

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When that happens, smart investors try to figure out if they got it wrong.

It’s okay if you did. To quote a wise man, it’s 100 floors of frights. They can’t all be winners. Not every investment will work out, and if they always do it’s probably because you aren’t taking enough risks. (After all, you could guarantee returns by purchasing nothing but Treasury bonds, but that won’t do much for your portfolio.) When your stock picks start falling it’s time to look back with a clear, if not ruthless, eye and decide whether it’s time to cut this investment loose.

You’re much better off cutting your losses than holding on to a bad bet. Get your liquidity back, put it into a stronger investment and rebuild the cash you lost.

But what about when you look carefully and still can’t find anything wrong with your analysis? That’s when it might be time to “average down,” which is just industry slang for buying more shares of a declining position.

If you’re confident that this is a good company, and the share price has recently fallen, then take the opportunity. You might be looking at market/systematic risk in action, or a short-term bias against that company, or fluctuations due to a particularly big shareholder, or any number of possible transient factors.

Buy more shares at a discount and wait for the market to move to you.