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As much as we aim to be dispassionate and impersonal automatons, investing is an emotional business, even more so given the dramatic economic and political headlines of late. Even the pros find it tough to keep an even keel: Just last week the Wall Street Journal profiled traders suffering from "flash-crash flashback," a post-traumatic stress condition prompted by the 900-point market drop one year ago.
Out of all J.P. Morgan's contributions to the financial world, one of the most enduring is his time-honored advice on how to cope with the sometimes crazy world of investing. When a friend complained of restless nights up worried about his stock holdings, Morgan's advice was to "sell down to the sleeping point." It's a useful, yet often misunderstood axiom.
Selling down to the sleeping point -- or taking only the risk which still allows you to sleep at night -- shouldn't be relied on to unmethodically dump your positions. There are plenty of reasons to sell a stock (bad earnings, weak technicals) but the worst possible motivation is fear. Emotions are not tools of cognition; we know rationally our anxiety about an investment has zero impact on its performance. Yet because our portfolios are attached to people, with families, bills, responsibilities and feelings, our P&L statement does unquestionably have a direct impact on our psyche -- and ability to slumber.
At the heart of Morgan's quote is restraint. When distressed over a particular holding, he doesn't advocate selling entirely, only "down to the sleeping point." The object, you must always remember, isn't to materially change your position in a stock, only to reduce it just enough to give you the temerity to stick with the trade even as if the market gets rough.
To that end, I define "selling down to the sleeping point" as making the tiniest possible change needed to calm your nerves but maintain your positions. Changes in goals, risk tolerance or outlook are all legitimate reasons to exit a position. But simply being scared about losing money shouldn't be one of them.
When tossing and turning over a position, it often helps to contextualize it. So even if I've lost money in Mitsubishi UFJ Financial Group (MTU) and am agonizing amid the nonstop disaster coverage out of Japan, I'm strengthened by the realization the stock is just one position in a portfolio including other stocks, asset classes and the now universally embraced emergency fund. Like a rodeo bull, markets often aim to throw us off their backs. A solid financial foundation gives us the assurance to be able to sleep even when stocks don't go our way.
If raising cash is the only means by which to get your 8 hours of sleep, you might find that what you sell to get to the sleeping point might not be the same asset that's actually keeping you up at night. Consternation over one investment is a great opportunity to prune the small, "meaningless" positions that constitute less than 1% of your portfolio yet we end up lugging around for years. Oftentimes liquidating these small trades can provide the psychological ballast, not to mention additional liquidity, to hold onto those bigger ideas which might be in the midst of correcting.
And if trimming your largest positions (or entire portfolio) is the only alternative, you might consider the use of "staggered stops" rather than indiscriminately dumping shares. So if a stock has dropped from $50 to $45 and I can't sleep, I'll sell a tiny amount while immediately setting stop loss orders to reduce my exposure at $44, $42 and $41. Because so much of investing is confronting the unknown, simply having an explicit plan in place to deal with the potential for future losses can be as effective as actually taking them at the time.
Emotions, including fear, are part of life and therefore part of the markets. But because the big money is made on the big moves, we can't let emotions guide our investments. Selling to the sleeping point, when property applied, is a great way of acknowledging our feelings without turning our portfolios over to them entirely.
Jonathan Hoenig is managing member at Capitalistpig Hedge Fund LLC. At the time of writing, Hoenig's Fund held positions in a security mentioned.
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